Personal loans are increasingly popular for handling unexpected expenses, consolidating debt, or funding significant purchases. For most of us, at some point in our lives, we’ll need some kind of additional funds to make our lives a little easier, be it for purchasing a new car or maintaining your home. While they can provide financial flexibility, personal loans come with specific risks, however, that borrowers should consider before committing. Understanding the advantages and disadvantages of taking out a personal loan is crucial before submitting your application for finance. In this article, we’ll examine the key risks associated with personal loans and tips to minimize them. So, what is the risk of a personal loan?
What is a personal loan?
Personal loans are a type of credit that includes a number of financial products. These loans vary in size from a few hundred dollars to a few hundred thousand dollars. Each comes with its own form of term length and interest rate. They can be used for pretty much anything – from purchasing a new appliance to home renovations. Loans are most often secured from financial institutions like a bank, a payday lender, or even an online lender. You essentially apply for the credit and then agree to the terms of repayment. If you’re accepted and your loan is finalized, your lender will typically deposit the funds into your bank account. When it comes to repaying your loan, you’ll need to repay the principal (the amount of funds borrowed), plus the interest (the fee for borrowing the money). Loans fall into two separate categories:
Secured loans
Secured loans are tied up with collateral, like a vehicle when you take out a car loan. Secured loans typically have lower interest rates and are more available to more individuals because they are viewed as more secure in that the lender can take your collateral as payment if you fail to make your repayments.
Unsecured loans
Unsecured loans, on the other hand, are not backed by any form of collateral. Your lender simply gives you funds based on the promise that you’ll make your repayments. The bank can, however, still collect the debt if you fail to repay. In this scenario, your debt will likely go to collections or legal action may be pursued against you for the value of the loan you took out.
What is the risk of a personal loan?
There are a number of associated risks when it comes to taking out a loan:
High interest rates
Personal loans often come with higher interest rates than other loan types, especially for individuals with lower credit scores. Over time, this can result in a much larger repayment amount than the principal, making the loan more expensive than anticipated. It’s a good idea to check your credit score beforehand and shop around for the best interest rate available to you. If you’re offered a high rate, consider alternatives like secured loans, which may come with lower interest.
Potential for over-borrowing
The relative ease of obtaining personal loans can sometimes encourage borrowing more than is necessary or wise. Over-borrowing leads to a higher repayment obligation that can strain monthly finances and make managing debt more challenging. Make sure to borrow only what you need and create a repayment plan that fits comfortably within your budget.
Impact on credit score
Taking out a personal loan impacts your credit score in several ways. The initial credit check can result in a slight dip, and if payments are missed or delayed, it can significantly damage your credit score. This makes it more difficult to secure favourable loan terms in the future. Only take on a loan if you are confident in your ability to make regular payments. Setting up automatic payments or reminders can help you stay on top of due dates.
Fees and penalties
Many personal loans come with additional fees, such as origination fees, prepayment penalties, or late payment fees. These extra costs can increase the loan’s overall cost and potentially catch borrowers off guard. Before accepting a loan, ask for a breakdown of all potential fees. Understanding the fee structure can help avoid unexpected expenses.
Risk of debt cycle
For some, personal loans can lead to a cycle of borrowing, or a ‘debt trap‘, where one loan is taken to pay off another. This creates a dependency on loans and makes it difficult to achieve financial stability. Avoid taking out loans to manage existing debt. Speak to a Licensed Insolvency Trustee if you’re struggling with multiple debts.
The unsecured nature of most personal loans
Personal loans are often unsecured, meaning they don’t require collateral. However, this lack of security means that lenders might charge higher interest rates to offset their risk. Additionally, if payments are missed, borrowers can face aggressive collection practices. Consider the loan’s terms carefully and think about whether a secured loan with lower interest might be a better option.
They can require collateral
If you don’t have a high enough credit score to qualify for a secured loan, you may have to pledge assets as collateral. This is most often the case with applicants who have a poor credit score. In the case of a secured personal loan, the lender can keep the collateral if you default. Common collateral includes assets like a borrower’s house, car, or boat.
What are the benefits of personal loans?
Personal loans can also be very helpful if used correctly. Here are some of the advantages:
Help you to build credit
When you take out a personal loan and make regular repayments towards your balance, this can help to improve your credit score. This is because your payment history makes up 35% of your overall credit score. On the contrary, this does mean you can also damage your score if you make late payments or default on your loan, making it much more difficult to obtain credit in the future.
Pay for purchases over time
As lenders provide personal loans as a lump sum amount upfront, you can then use this to make a purchase or to pay off another debt. This means you can secure an item first and then pay it back over time, without the need to save in advance. This can be very helpful for purchases that are needed, but it can also become a slippery slope if you rely on loans for unnecessary spending.
Consolidate your debts
Debt consolidation loans enable you to simplify your debts and reduce the interest rate with a single personal loan. This, in turn, can help to improve your credit score. Some lenders specialize in debt consolidation and will pay off your debts directly instead of first depositing the money into your account.
You can use loans for almost anything
Personal loans are popular because they can be used for virtually anything, from personal to home repairs to weddings. The use of a loan can be determined by some lenders, and some will restrict the purpose of the funds.
Competitive rates
Personal loan annual percentage rates (APRs) typically range from 3% to almost 50% with the most competitive rates reserved for high-qualified applicants. While the upper range of rates can get high, many applicants qualify for an APR lower than what is available with a standard credit card. These rates are, however, still higher than secured loans like home equity loans. If you’re considering whether or not to get a personal loan, take time to prequalify with top lenders to see what kind of rate you’re likely to get.
Flexible borrowing limits
Borrowing limits vary by lender, but personal loans are typically available between $500 and $50,000. For this reason, personal loans can be tailored to meet the borrowing needs of most consumers. Just keep in mind that getting a $50,000 personal loan will likely be more challenging than qualifying for a smaller, less risky sum. Alternatively, if you’re planning to finance a smaller purchase, a credit card or line of credit might be more appropriate.
No need for collateral
Most personal loans do not require the borrower to pledge any collateral. This means you won’t have to risk losing a valuable asset – like your home or car – if you default on the loan. Keep in mind, however, that unsecured loans typically come with higher interest rates and may be more difficult to qualify for because they pose more risk to lenders.
Fast access to cash
Personal loan application processing and funding speeds vary, but many lenders advertise same- or next-day funding. So, if you’re facing unexpected auto repair costs or emergency travel needs, a personal loan may be feasible. If you need funds in a hurry, it’s important to carefully research the entire loan application process. The actual time it takes to apply, get approved, and receive loan funds can be longer depending on when you apply, the size of the loan, and how quickly your bank lets you access the money after it is disbursed.
What is the risk of a personal loan? FAQs
Here are some of the most commonly asked questions we receive about the risks associated with a personal loan:
Is there a risk to borrowing money from a personal loan?
Yes, borrowing money from a personal loan does carry risks. High-interest rates can make repayment challenging, especially if you have a lower credit score. There’s also the chance of over-borrowing, which can strain your finances and lead to a cycle of debt. Additionally, personal loans often come with fees like origination or late payment fees that add to the overall cost. Missing payments can harm your credit score, making it harder to secure favourable loan terms in the future.
Is it bad to take out a personal loan?
Taking out a personal loan isn’t inherently bad; it can be a practical solution for handling expenses or consolidating debt. It’s important to consider the terms carefully, however. Personal loans often come with higher interest rates, which can make them costly over time, especially if you miss payments. If managed responsibly and only when truly needed, a personal loan can be a helpful financial tool, but relying on loans frequently can lead to debt accumulation and potential financial strain.
What is the risk of a loan?
The main risks of a loan include high interest rates, which can lead to paying back much more than the amount borrowed, and the potential for debt accumulation if repayments are missed. Loans often come with added fees, like origination or late payment fees, which increase the total cost. Failure to keep up with payments can hurt your credit score, making it harder to borrow in the future. In cases of unsecured loans, the lender may resort to aggressive collection tactics, adding stress to financial strain.
Is a personal loan right for you?
A personal loan can help you to fund a number of different products and services. When used responsibly, they can prove to be very helpful, but as with most things, they do come with risks. Arguably the biggest risk of a personal loan is its ability to trap you in a cycle of debt if you borrow more than you can afford. Personal loans also typically have high interest rates, and can come with hidden fees. Be sure to carry out appropriate research before taking out a personal loan so that you’re well prepared for what you’re committing to. If you have specific questions or are worried about the debt you are taking on, speak to a reputable Licensed Insolvency Trustee. A personal loan might be right for you if you:
- Have a good credit score that will help you meet the eligibility criteria for a low interest rate
- Are able to afford a new monthly payment
- Want to consolidate multiple higher interest debts
- Have a debt to income ratio of no more than 45%
- Will not be able to qualify for a low-interest credit card
- Are tackling a project like a renovation that will add value to your property
Personal loans can be a valuable financial tool when used responsibly, but they are not without risks. By carefully evaluating your financial needs and understanding the terms, you can make informed decisions to protect your financial health. Always consider consulting a Licensed Insolvency Trustee if you’re concerned about the amount of debt you’re taking on. You can book a free, no-obligation consultation with Spergel.