7 risks of taking out a personal loan

Key takeaways

• High rates can make loans much more expensive, especially if you opt for a longer term to keep monthly payments low.

• Larger loans come with larger payments that can be difficult to handle if your income suddenly drops.

• Origination fees, early payoff fees and late fees can quickly add to the total cost of a personal loan.

• Easy qualifying standards can lead you to borrow more than you need and increase your debt load.

Despite how simple it is to qualify for, there is risk associated with taking out a personal loan. Like any type of loan, you need to be cautious about how much money you borrow and consider your ability to pay it off. This is especially true with personal loan interest rates at higher-than-usual levels after nearly two years of Federal Reserve rate hikes.

1. A high APR if your credit is bad

Although average personal loan rates can be as low as 10.73 percent for borrowers with an excellent credit score they may be as steep as 32 percent for borrowers with poor credit.Interest rates are based primarily on your credit score. The lower your credit score is, the higher your APR will be.

• How to reduce risk: Compare rates with several lenders. Some lenders specialize in poor credit personal loans and may offer lower rates than others that focus on excellent credit consumers. Take steps to improve your credit score like using credit cards sparingly and paying your bills on time, all the time.

Bankrate expert insight: The APR you’re offered is a sign of how risky you are to lenders.

“Personal loan lenders won’t tell you you’re risky, they’ll show you based on the rate and terms they quote you. If you receive rate quotes at APRs higher than you expected, take some time to review your credit score and take steps to improve it. The extra effort may improve your odds of getting future loans at better rates and terms.”

– Denny Ceizyk, Bankrate Senior Loans Writer

2. Borrowing too much money

Personal loans are relatively easy to qualify for, and easy access may come with the temptation to borrow too much. The larger the personal loan, the higher your interest rate and payment will likely be. Borrowers often choose longer repayment periods to reduce the payments on large loan amounts, which means they pay more interest for a longer time period.

• How to reduce risk: Consider how much you really need, and don’t borrow any more than that. Use a personal loan calculator to determine how interest you’ll pay over the life of your loan to avoid over borrowing.

3. Increasing your total monthly debt

Unless you’re using a personal loan for debt consolidation, you’re adding monthly debt that increases your debt-to-income (DTI) ratio. If your DTI ratio is too high, you might have a difficult time qualifying for a car loan or a mortgage in the future.

Another disadvantage of personal loans is the terms aren’t usually more than five years, which could leave you with a payment that squeezes your budget.

• How to reduce risk: Use a debt-to-income ratio calculator to see how much your debt would increase compared to your income. If it’s too high, consider borrowing less or holding off until you can pay down other debts.

4. Paying fees

Sometimes the lowest advertised rate at the best terms comes with hefty fees. Read the fine print to avoid expensive origination fees. Watch out for prepayment penalties which some lenders charge if you pay off your loan before a certain time period.

• How to reduce risk: Check your paperwork before you finalize a personal loan and ask about any fees that were not part of your initial prequalification. If there’s a prepayment penalty, ask the lender if they offer options without one.

5. Not considering other options besides a personal loan

Make sure you’ve researched all of your options before you take out a personal loan. Consider options that increase your income, reduce your expenses or are cheaper financing options than a personal loan.

• How to reduce risk: You could take on a side hustle to earn more income instead of borrowing. Check your budget for any spending leaks like eating out too much and use any budgeted savings to up your emergency savings. If you’re a homeowner, check out a home equity loan or HELOC which allows for terms as long as 30 years, giving you a much lower payment than short term personal loans.

6. Falling into a debt spiral

If you’ve used a personal loan more than once to consolidate credit card debt, you may be caught in a debt spiral. If you don’t have a plan to address spending beyond your budget, you’re likely to keep repeating the debt cycle over and over.

• How to reduce risk: Only agree to personal loan terms that you can truly afford so you do not end up building more debt. Also, avoid using other open forms of credit while you pay back your debt. Consider credit counseling if you need someone to help you with a debt management plan.

7. Damaging your credit by missing payments

Any missed payments will result in delinquency, which could damage your credit score. Your payment history has a greater impact on your credit score than any other credit factor, so it is important to keep it in check.

Also don’t apply for too many personal loan credit accounts at once. Each time you apply, you will likely undergo a hard credit pull, which can negatively affect your score.

• How to reduce risk: Set up automatic payments to ensure you never miss a monthly payment. If you are comparing rates, apply for prequalification to avoid multiple hard credit pulls.

Are personal loans bad?

Personal loans can be bad for your finances if they are used as a bandaid for poor spending habits. However, they can be a great tool to simplify your debt, pay off high interest rate cards and could even help you improve your credit score over time.

While there are a significant number of risks associated with any type of loan, if you do your research, apply with reputable lenders and stick to a budget you should be able to find a loan that fits your needs.

• Apply for what you need. Even if you can afford the monthly payment on a large loan, only borrow the minimum amount you need to avoid paying additional interest.

• Check fees first. Origination fees, prepayment penalties and late fees can add up. Confirm the exact amount you will be expected to pay, and make your payments on time to avoid additional fees.

• Compare at least three lenders. Most lenders — including large banks — allow you to prequalify for personal loans. This allows you to check your rate without harming your credit score.

• Develop a budget. Similar to borrowing only what you need, have a budget in place to ensure you can consistently repay your loan. Be willing to reach out to your lender if there are any changes to your finances.

You should also have a specific purpose or financial goal when hunting for a personal loan. Avoid financing vacations or holiday expenses and add to your savings as often as you can to avoid needing loans for unexpected emergencies.