Common Loan Pitfalls and How To Avoid Them

A loan can be used for a variety of purposes. Just a few examples include consolidating credit card debt, consolidating school loans, and dealing with unforeseen medical bills. Of course, they can also be used to fund a range of other activities, like starting or expanding a business or renovating a home. However, before applying for a personal loan, it is critical to understand how they work.

Consider the following loan risks when you make the appropriate modifications, as they may hinder your efforts to build your wealth and financial net worth.

High-Interest Rates

A high-interest loan has an annual percentage rate (APR) greater than 36 percent, which most consumer advocates regard as the highest acceptance rate. Loans with high-interest rates are available from online and brick-and-mortar lenders who provide quick cash and simple applications, often without requiring credit verification.

Because most personal loans are not secured by collateral, lenders regard them as riskier investments. As a result, they frequently have higher interest rates. Personal loans, in general, have higher interest rates than secured loans like home equity loans and home equity lines of credit, as well as small-business loans and other types of loans.

Fixed Versus Variable

When it comes to personal loans, the interest rate influences both the monthly payment and the overall cost of the loan. As a result, it is critical to understand your interest rate and whether it is fixed or variable. Variable interest rates may appear appealing because of their low starting points. However, they have the potential to grow over time, rendering your loan unaffordable.

Before obtaining any form of loan, it is critical to properly investigate the annual percentage rate (APR), which computes the loan’s final cost. The higher the APR, the more interest and borrowing expenses you will have to pay throughout the life of the loan.

Interest Rate Estimates

Since personal loans are unsecured, lenders place a premium on your credit score when determining your ability to repay the loan. Individuals with good credit, defined as a FICO score of 760 or more, typically qualify for lower APRs on personal loans than individuals with lower credit scores. 

If your credit score is less than 670, you have a subprime credit score, making obtaining a competitive APR — and returning a loan in full according to the terms provided — much more difficult.

Fortunately, the interest rate on a personal loan is determined by factors other than your credit score. Lenders generally prefer a consistent source of income and a low debt-to-income ratio. If you’re worried about getting stuck with a high-interest rate, now might be a good time to work on improving your credit.

High Fees and Penalties

The origination charge is one downside of a personal loan. The origination fee is distinct from the interest rate on loan. This is a loan account payment based on the entire loan amount percentage.

This number could be anywhere between one and six percent. As a result, origination fees can significantly increase the cost of a personal loan. When you receive a personal loan, you may be forced to pay the following fees:

  • Fees for applying.
  • Loan origination fees.
  • Penalty for early payment.
  • insufficient funds (NSF).
  • Late payment penalty.

Make sure to address fees with your lender so that you are fully informed. It’s a good idea to inquire about the costs involved with your loan upfront since this will allow you to determine whether the overall repayment is worthwhile. 

Also, see if any costs may be waived — you’d be shocked what you can have waived if you do some research and speak up (research online or talk to friends and family to see how others were able to get fees waived). A personal loan has several major disadvantages, including transaction fees, late payment fees, and origination fees.

Credit Damage

One significant downside of a personal loan is that if you are unable to make on-time payments or get behind on your payments, your credit score will suffer. Personal loans are typically unsecured, which means that they do not require security, such as a home or car, in the event of default. 

On the other hand, the loans are secured by your pledge to repay the lender. On the other hand, some personal loans are secured by collateral, such as a savings account or certificate of deposit. Borrowers typically take out secured personal loans to increase their chances of receiving a favorable interest rate, especially if their credit is less than excellent.

If you repeatedly skip payments on unsecured and secured loans, your credit history may suffer. A single late payment, for example, might cause a 100-point decline in your credit score, lowering it from “very good” to “average.” If you continue to miss payments, your credit score may suffer further harm.

Hard Check

Applying for a personal loan triggers a hard inquiry, which can impact your credit score and stay on your credit record for two years — yet it is a necessary step in the process for the vast majority of loans. Late or missed loan payments will almost certainly negatively influence your credit score.

Set up automated bill pay if you have trouble remembering due dates. (Using a smartphone app makes the process easier.) Once you’ve joined up and established that you have enough cash in your account to cover your payments, your payment problems will fade into the background, and your payments will be processed on time. You can also use cash advance apps to help pay your personal loans to increase your credit score.

Preemptive Actions

Before asking for a personal loan, you should evaluate your financial status and consider the following. 

  • Are you in a position to make your loan payments? Check your monthly budget to ensure your calculations are accurate.
  • Consider your schedule; if you can wait, consider saving the same amount of money each month that you would have paid on a personal loan until you have enough money to cover your large expense.
  • Do you have a high enough credit score to qualify for a low-interest rate? If not, think about improving it before applying for a loan.

Now that you know what a personal loan includes, go ahead and shop around, do some research, and evaluate your needs and desires. Your ideal bathroom renovation or vacation could be right around the corner.