Written by Anne-Marie Hays | September 11th, 2019Anne-Marie Hays is a Content Management Intern with Best Company. She enjoys comedy, hates crowds, and loves that you are reading this bio.
"Personal loans have served the general public as useful financial tools for years on end, and that's not likely to end anytime soon," says Sean Messier, Credit Industry Analyst from Credit Card Insider. "But with that said, they certainly have their limitations, and you should know what they are before heading to your local credit union to borrow a few grand."
We asked personal finance experts to help us understand the different risks that borrowers should be aware of. Here's what they said:
Risk #1: Borrowing more than you need
"While more money up-front may seem like a good thing, taking out a larger personal loan than you actually need can lead to troubles in the future," advises Logan Allec, a CPA and owner of personal finance site Money Done Right.
"For example," says Allec, "if you're taking on a loan to start your own business and you're approved for more than you need, just remember, you're going to have to pay the loan back in its entirety!
A loan is just that — a LOAN.
If your bank says you're qualified for more than you requested, simply say you don't need the extra amount. Stay strong and stick with the original loan you planned on! If you're successful, your business will generate money for you anyway!"
Risk #2: Unnecessary debt for wants
"One risk of taking out a personal loan is that you could be falling into debt when that's not necessary," says David Bakke, a personal finance expert at Money Crashers. "If you need a personal loan for 'needs' (such as transportation, housing, or medical care) that's one thing. But taking out a personal loan to take a vacation just doesn't make sense."
Taking on debt that you actually don't need is a risky behavior.
Jared Weitz, CEO and founder of United Capital Source Inc, puts it this way: "In the moment, you might scramble and think you need a loan or take one out for an unnecessary vacation or home improvement project. You are now faced with paying off the loan and adding the interest to the loan when in reality, you could have avoided this all together."
"Instead," Weitz suggests, "look at your budget closely and see where you can cut corners if you do need extra money. And if you are looking for a 'want' purchase, consider how much it will actually cost once paid off and whether it's actually worth what you are paying." Bakke adds, "Simply wait until you can save up the money to buy whatever you want to buy without borrowing."
Risk #3: Paying high interest rates because you didn't compare rates
"Lenders usually attract borrowers by advertising low interest rates for personal loans," explains Mike Cornu, Senior Consultant at NewSilver.com. "But these lower rates are typically reserved for those who have excellent credit. If this isn't your case, you will be offered a higher interest rate.
So, if you decide to apply for a personal loan, it is best to research and compare multiple offers from different lenders. Statistically, consumers can save as much as 35 percent if they compare interest rates before accepting a loan offer.
In case you find a promising lender, carefully review the loan documents and get a clear understanding of how much the loan will actually cost you: upfront fees, interest rate etc. Take the time to read their offers carefully; ask questions."
Risk #4: Falling prey to variable rates
"You might get caught with an inflated interest rate when you sign up for a loan with a variable rate," warns Weitz. "There is a risk associated with variable rates on loans considering the interest rate can shift depending on the market rate. This can spike up if the market has a large shift and put your interest rate at an unmanageable level.
Be careful to consider your timeline to pay off the loan and the budget you have available for any forecasted changes."
Risk #5: Incorrectly comparing loan options
"One of the basic risks of a personal loan is incorrectly comparing different options," advises Lou Haverty, CFA and creator of Financial Analyst Insider. "The most often this comes up is when comparing loans with different fee structures.
For example, a $2,000 loan with a 10 percent rate vs. an 8 percent rate with a 5 percent origination fee. At first glance, it looks like the 8 percent rate is the better option. But when you compare the options with an APR rate, you find out that option two has a 13 percent APR vs. a 10 percent APR for option.
Loan fees can increase your annual percentage rate much more than it might look on paper.
Always compare personal loan rates using an APR rate. It's the only way to compare different options on an equal basis."
"Before you commit to one lender," advises Allec, "be sure to shop around and see what the best deal is. Some banks may not charge any origination fees, while others may take a smaller amount than others."
Risk #6: Not being able to make payments
"Personal loans require you to pay at least a fixed amount monthly," says Messier. "If you're not absolutely confident that you'll be able to make those payments without a hassle, then you may land yourself in an ever-growing pile of debt, which could ultimately destroy your credit scores and leave you struggling financially."
Zina Kumok from DollarSprout.com agrees. She says, "The biggest risk with a personal loan is that you won't be able to afford your payments if something happens, like a job loss or a medical emergency."
With personal loans, lowering monthly payments and refinancing aren't always available, she explains, because "there's no collateral behind it, unlike a mortgage or auto loan."
How do you guard yourself against this risk?
"The best way to avoid [being unable to make your payments]," suggests Kumok, "is to not take out more than you can comfortably pay off. If possible, pay extra when you can and try to pay off the loan as quickly as possible."
Risk #7: Loan fees can add up
"One risk in taking out a personal loan is having to pay additional fees such as origination fees and prepayment fees," advises Xavier Epps, founder and CEO of XNE Financial Advising.
"Even if you always pay back your loan on time and don't generate any late fees, you may still be responsible for fees up-front," explains Allec. "These are known as "origination fees" and can take away from the amount of the loan you actually receive."
"A Prepayment fee is a charge on paying a loan off early," explains Epps. Paying back the loan entirely before the agreed-upon timeframe can "cost you big time if you don't read the fine print," advises Bakke.
This fee can be a very unwelcome surprise, as Becky Beach, a finance blogger at MomBeach.com shares:
"A year ago, I took out a personal loan of $5,000 to pay off some credit cards with high APR. The APR of the unsecured personal loan was significantly less at 10 percent APR than the 24.9 percent (on average) of the credit cards. I thought I could pay off my bills and save more money in the process. When my business brought in unexpected extra income, I was able to pay off the personal loan early.
However, I incurred a prepayment fee for paying it early that I wasn't aware of. A risk to take when taking out a personal loan is that you might have to pay a fee if you pay it off too early. Some lenders won't charge a fee, but the bank I borrowed from, Frost Bank, did.
Those taking out personal loans should always read the fine print and be aware of any additional fees they will incur before making a decision."
Epps adds, "The best way to avoid these additional fees is to compare loans from several lenders and understand the various loan terms. Then see which loan offer aligns with your needs and ability to pay off the loan."
Risk #8: Effects to your credit score
"When you apply for a personal loan, lenders will perform a credit check on you to evaluate the risk you pose to them in terms of paying back the loan," explains Allec. "However, these inquiries often deduct points from your overall [credit] score, which can make it even harder to obtain loans — or whatever else you may need — in the future. Be wary of this before applying through a bunch of different lenders."
While having a few points deducted when you apply for a personal loan can hurt your score, there is a bigger risk to your score than just the hard credit inquiry.
"One of the biggest risks of taking out a personal loan is the impact on your credit rating should you not be able to meet a repayment deadline for any reason," explains Helen Chen, Director of My Cash Online. "Missing just one repayment can lead to a mark on your credit report, impacting your chance of being approved for credit for two years into the future."
What should you do?
Chen advises, "As soon as you realize that you may not be able to make a repayment as contracted, the best course of action is to contact your lender. They are often willing to help restructure your debt or put a hold on payments to avoid a listing on your credit report."
"Whatever you do," says Chen, "do not borrow more money to cover the missed repayment as this will just make the problem worse the next month"
Risk #9: Defaulting on your loan
"The most important risk is defaulting on the loan," cautions Robert Linker from Family Debt Planning. "If you already have other debts then you should probably be worried about making payments on a new loan," he says. "How people get into trouble with debt is rolling up small debts that turn into big problems. That is why credit cards are so dangerous."
How do we avoid defaulting?
"Make sure you budget enough money each month to make your payments," says Linker. "In fact, don't take out the loan until you have incorporated the monthly payments into your budget."
What should we do instead?
Linker gives this advice: "The simple answer for this is to spend less. Make sure what you want to take out a loan for is very important, either an emergency or something that you can't live without. If you do need the loan, see if you can consolidate your debts. Other loans that you may be able to refinance for extra cash are car loans and mortgages."
Risk #10: Getting sucked into a cycle of debt
"When you take out a personal loan, you have to be diligent to not allow it to make you feel more financially free," cautions Ryan Inman, founder of Financial Residency. "You may have paid off credit card companies and even a private student loan company [with your personal loan], but you've really only changed who you owe. You've not gotten out of debt."
To avoid falling further into debt, he urges borrowers to "eliminate excess spending, focus on paying off your personal loan, and not continue to spend more than you make."
Risk #11: Bringing a co-signer into your credit mess
"Taking out a personal loan may also carry the additional risk of needing a co-signer," explains Inman. "When you originally accumulated the debt [that] you're likely using a personal loan to pay off, you may have had minimal debt or not had your credit-worthiness and income as closely examined."
"With a personal loan," he says, "you'll be evaluated more closely and the loan grantor may require a co-signer. The danger in that is if something happens and you default, now that other person is on the hook for your debt. You can endanger someone's retirement, for example."
Risk #12: Not looking into lower-cost loan types
"Personal loans involve borrowing a lump sum of money," explains Messier, "and then repaying that money plus interest. While the interest rates on the typical personal loan may look low, they can add up, costing you hundreds or even thousands of dollars over time, especially if you're dealing with a longer repayment period."
While it costs much less to borrow a personal loan than a payday loan, you may have better options.
"Typically, personal loans will have higher rates and shorter periods to pay back the lender," says Michael Drake, President of PMG Home Loans. "A better option, if you qualify, is a home equity line of credit — lower rates and ten years or more to pay it off."