Top5 Loans to Avoid

By AnnaMaria Andriotis,
Reporter, SmartMoney.com

As the credit crunch picks up steam and lenders increasingly cut credit lines and deny financing, consumers with shaky credit – those who have a credit score of around 660 or lower – are left with few favorable lending options. But if they're willing to pay up -- say by incurring triple-digit interest rates or strict penalties -- then the opportunities seem almost endless.

For these borrowers, there's no shortage of companies willing to offer them payday loans charging 400% interest or car title loans that require your car as collateral. Take a loan against a 401(k) and the financial costs are plentiful when you start adding up all of the potential fees you could incur.

Even worse, unless such loans are quickly paid in full (say within a month or so), most borrowers will be left with more debt and less savings than they originally had, says Linda Sherry, a spokesperson for Consumer Action, a nonprofit consumer education and advocacy organization.

Consumers looking for fast cash should avoid these five loans:

1. Payday Loans

Payday loans are short-term cash loans often ranging from $300 to $500 that are only worth it if a borrower has no other options left, can't use a credit card and are able to pay the loan back quickly, says Leslie Parrish, a senior researcher at the Center for Responsible Lending (CRL). Otherwise, they'll land the borrower deeper into debt.

To get a payday loan, you need to show proof that you have a checking account (with a check) and a job (with a pay stub) or some other source of verifiable income like Social Security benefits. As collateral, a personal check to the payday company for the amount being borrowed plus interest, which they're told about before agreeing to the loan, is required. Should the borrower not repay his debt, the company will then cash his check.

But that's far from the worst thing about these loans. Payday loans often carry an annual percentage rate of 400% or higher, says Parrish. The deadline to repay the loan in full is your next payday, but borrowers often don't have enough money and end up renewing it, she says. To renew a payday loan, you pay a fee of around $15 for every $100 and, in essence, re-borrow the money. It's a lucrative business for payday lenders: Renewal loans total more than $20 billion a year in business for them, according to the CRL.

Payday loans aren't authorized in 10 states: Connecticut, Georgia, Maine, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Vermont and West Virginia all outlaw them. And, interest-rate caps on payday loans of between 17% and 36% have been set in Arkansas, Washington, D.C., New Hampshire, North Carolina and Ohio. Arizona is expected to join this list in July 2010.

Click here for other types of loans to be wary of.

2. Car Title Loans

Car title loans are often a consumer's last hope for financing, says Jean Ann Fox, director of financial services at Consumer Federation of America (CFA). And they also carry some pretty big consequences: Default on the loan and the lending company will take your car.

Car title loans are based on a fraction of what your car is worth, averaging 55% of its value, according to a 2005 report (the most recent) by the CFA. The median smallest loan amount is $175 and the highest is $2,500, according to the CFA's report. To qualify for the loan, borrowers need a car that they own outright.

Most car title loans need to be repaid in one month, but a borrower can hold onto their car as long as they repay a portion of the loan and renew it for a fee each month, says Fox. On average, these loans end up charging consumers 300% in APR, she says.

3. Cash Advances

Credit card issuers may be cutting credit lines, but they aren't cutting back on offering cash advances. And for good reason: The average interest rate on a cash advance is 22%, up from 19% in 2005, says Josh Frank, a senior researcher at the Center for Responsible Lending. And fees range between 3% and 5% of the cash advance amount, he says.

Most consumers have a hard time paying down this balance, especially when they have an existing balance for purchases on the same account. Credit card issuers tend to apportion monthly payments to the balance that carries the lowest interest rate first. If your APR on purchases is lower than that for cash advances, which is typically the case, then monthly payments will go toward purchases while the cash advance balance continues to grow.

Thanks to the new credit card legislation that will be put in place beginning in February 2010, monthly payments will start being put toward the highest APR balance first. But until then don't expect to pay that cash advance off anytime soon as long as you have an existing balance.

Click here for more on credit cards.

4. Overdraft Loans

Banks used to deny debit card purchases when a consumer didn't have enough cash in their checking account to cover the bill. Now, it's almost standard operating procedure to let those transactions go through.

After all, such transactions trigger lucrative overdraft fees of on average $34 per occurrence, says Rebecca Borné, policy counsel at the Center for Responsible Lending. In addition, banks often embark on some practices that make incurring these fees easier. Some banks will change the order in which debit transactions clear – and clear debits before clearing any deposits made – in order from highest to lowest amounts. This depletes the customer's account quickly causing them to incur more overdraft fees, says Borné.

To avoid taking such a hit, buffer your account with an extra $100 that you don't intend to spend. That way, small day-to-day transactions won't end up costing you more. Even better, ask the bank to set the debit overdraw amount on your account to zero.

For five sneaky overdraft traps, read our story. And click here for more bank secrets.

5. 401(k) Loans

Most 401(k)s permit account holders to borrow up to half of their balance or $50,000, whichever is lower. Doing so, however, can wreak havoc on your retirement plans, says David Wray, president of the Profit Sharing/401(k) Council of America, a nonprofit that studies 401(k) trends.

Borrowers who take out a 401(k) loan often have five years to repay the borrowed amount. In essence, you pay yourself back via payroll deductions at an interest rate of prime plus 1%, which currently equals 4.25%. Should you leave your job, however, you'll have to repay any remaining loan balance immediately. Otherwise, the loan gets deemed a distribution in the eyes of the IRS, and you'll get hit with income tax and (if you're under age 59 ½) a 10% early withdrawal penalty.

For more on 401(k) loans, click here.

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