When you borrow money through a personal loan, there is always some level of risk involved, just like with any financial activity. It is crucial to be careful about how much you borrow and make sure you will be able to repay it. This is particularly important now because interest rates are currently elevated due to the Federal Reserve’s ongoing base rate increases.
5 risks of taking out a personal loan
Please identify the typical hazards associated with obtaining a personal loan and learn how to reduce their impact.
1. Signing off on a steep APR
Not all personal loans are financially sound options, as interest rates differ based on the lender and your financial status. Therefore, being eligible for a personal loan does not necessarily mean it is a wise decision.
Your credit score affects your interest rates. If your credit score is low, your interest rate will likely be high. People with excellent credit scores may get rates as low as 10.73%, while those with poor credit may face rates as high as 32%.
How to mitigate risk: To find the best lender, be sure to compare interest rates and also consider factors like education and employment history.
2. Taking out too large of a loan
It’s important to tread cautiously when considering a big loan. Taking on a larger personal loan often means you would also be taking on a higher interest rate. Additionally, a bigger loan also entails longer repayment periods which, in turn, could accumulate more interest over the lifetime of the loan.
How to mitigate risk: It’s recommended to use a personal loan calculator before borrowing to understand how interest accumulates over time. This will also help you borrow only the amount you need.
3. Damaging your credit
It’s important to avoid missing payments because it could lead to delinquency and potentially harm your credit score. Your credit score is a crucial factor in your financial situation, so it’s essential to keep it in good standing. Additionally, try not to apply for multiple credit accounts at once, as each application could result in a hard credit pull that may negatively impact your score.
How to mitigate risk: To prevent missing monthly loan payments, consider enabling automatic payments. When comparing interest rates, try obtaining prequalification to avoid a hard credit inquiry.
4. Getting stuck with fees
It is important to read the fine print before getting a loan, even if it has a competitive interest rate and favorable terms. Some lenders charge fees for loan origination, and some may charge extra for paying off the loan earlier than expected.
How to mitigate risk: Some lenders might not inform you of their anticipated fees prior to your application. Keep a watchful eye and inquire about any possible extra fees before proceeding with your application.
5. Falling into a debt spiral
If you don’t have a plan, taking out a personal loan for debt consolidation or borrowing money from any source can put you at risk of falling into a debt spiral. It’s crucial to think about this and make sure you’re not using the loan to pay off your credit cards only to accumulate more debt on them later.
How to mitigate risk: Make sure you can genuinely afford the terms of a personal loan before agreeing to it. This will prevent you from accumulating more debt. Additionally, refrain from utilizing other available forms of credit while paying off your debt.
How to use a personal loan responsibly
Although borrowing any type of loan comes with a substantial amount of risk, it is possible to be responsible with the money you borrow. You can find a loan that meets your requirements by conducting thorough research, applying with reputable lenders, and adhering to a budget.
- Apply for what you need. To avoid paying extra interest, it’s better to borrow only the essential amount you require, even if you have the capacity to pay the monthly installments for a larger loan.
- Check fees first. Make sure to double-check the total fees you need to pay, including origination fees, prepayment penalties, and late fees. To avoid any extra charges, be prompt in submitting your payments.
- Compare at least three lenders. You can prequalify for personal loans with many lenders, even large banks. Prequalification allows you to check your loan rate without negatively affecting your credit score.
- Develop a budget. To make sure you can repay your loan on time, it’s important to set up a budget and only borrow what you need. Also, don’t hesitate to contact your lender if there are any changes to your financial situation.
When looking for a personal loan, it’s essential to have a clear purpose. While a vacation can be costly, it’s not the most responsible reason to borrow money. Instead, it’s advisable to use a personal loan for home improvements, large bills, or other necessary expenses to avoid overspending or borrowing more than you can afford.
Next steps
To obtain a personal loan, it’s important to compare different lenders such as credit unions, banks, finance companies, or lender networks. Take the time to understand the available rates and how interest will accumulate throughout the duration of the loan. Plan your approach carefully.