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A personal loan can help you finance expenses, consolidate debt, reduce payments to a more affordable level or help improve your credit score by reducing the balances on credit cards—but there are risks worth considering.
A personal loan can also help you dig yourself into an even deeper hole, and some come with costly features that are easy to overlook if your focus is solely on getting approved. So it's smart to know what to watch out for.
Here are five risks of taking out a personal loan.
1. High Interest Rates
The interest rate you'll pay for a personal loan will be related to your credit score. A high credit score will usually qualify you for a personal loan with a lower interest rate, while a low score could leave you paying a higher rate. If you're turning to a personal loan because you can't get approved for a lower-cost financial product such as a credit card with a teaser rate, check the loan's interest rate carefully.
Likewise, if you've struggled to afford your monthly bills, and a personal loan is going to offer lower payments, be sure you understand how long you will be paying and the total cost of the loan once interest is calculated.
2. Prepayment Penalties
Prepayment penalties are fees that are imposed when you pay off a loan before it is due. Some lenders charge them to help make up for the money they expected to earn from interest charged on the loan. The best way to know if a loan has a prepayment penalty is to ask the lender directly. They must be disclosed, but sometimes that disclosure could be in the fine print of your loan documents.
Prepayment penalties and other fees can increase the amount you will ultimately owe on a personal loan. Not every personal loan has a prepayment penalty, so it pays to ask.
3. Origination Fees
Origination fees are a percentage of the loan the lender charges as a cost of doing business and as such, they add to your costs. Not every lender charges them, but some that don't instead charge higher interest rates.
Origination fees can be up to 15% of the amount borrowed. An origination fee may be added to the loan balance or subtracted from the amount you receive. If, for example, you borrow $10,000 and have a 5% origination fee, you might receive $9,500, or perhaps owe $10,500. Be sure you understand how that will work, and plan accordingly.
4. Higher Overall Debt
If you take out a personal loan to consolidate credit card debt, it's smart to try to get a lower interest rate—but that should not be your only consideration. If a credit card with plenty of available credit tempts you to overspend and you charge it up again, you could wind up with more debt than when you started. However, if a debt consolidation loan is part of an overall plan and you have addressed the habits that led to high credit card debt, it can be a good idea.
5. Damage to Your Credit Score
While you are checking rates and terms, it's a good idea to also check the credit scores of people whose applications are typically approved if that information is available. You can also look for an option to prequalify online without a hard inquiry or "hard pull." A hard credit inquiry can ding your credit score temporarily, and that is true whether you get approved or not. If you can't prequalify, you may not want to risk the loss of a few points that can happen if you actually apply. Choose a loan you're likely to be approved for.
How to Minimize the Risks of a Personal Loan
Tempting as it is to apply for a loan because you need something now but you don't have the cash, take a minute to think some things through. For example:
- Review your budget to be sure you have enough room to add a payment, and what the maximum size of that payment could be.
- Shop around for a personal loan. Such loans are offered online, at banks and at credit unions. You might want to start with credit unions, because they are not-for-profit and tend to have lower rates and fees.
- Consider setting up autopay if you get approved for the loan. Be sure to use an account that reliably has enough money in it to make payments so you don't overdraw your account. On-time payments are crucial, because a payment reported as 30 days late can devastate your credit score.
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The Bottom Line
A personal loan can be a useful financial tool, but not all personal loans are exactly alike. If you're looking to apply, check interest rates, fees and prepayment penalties. Then make sure your budget has room for the new payment and that you have a solid plan for paying on time, every time.
A comparison tool like the one from Experian can help you find a personal loan without risking an unnecessary hard credit inquiry. You can set up a free account, log in and submit a personal loan prequalification request—and it won't affect your credit. Once you apply or accept the loan offer, your lender will likely do a hard inquiry as a final credit check.