In the first quarter of 2018, more than 19 million unsecured personal loans remained outstanding, with the average debt per borrower totaling just under $8,000, according to TransUnion. With so much flexibility in how personal loans can be used, more and more consumers are turning to these debts as a way to finance home improvement projects,Â vacations, large purchases,Â consolidateÂ debt, or even to close a gap in education funding.
Like all installment loans, personal loans are for a specific dollar amount and are repaid over a predetermined period of time â€” typically anywhere from 24 to 60 months, depending on the lender.
While the flexibility of a personal loan is an appealing feature, there are mistakes consumers tend to make when pursuing this type of financing. Unfortunately, those mistakes can cost you a significant amount of money over the life of the loan.
Here are some common pitfalls to avoid when taking out a personal loan.
â€śA personal loan can be a more expensive way to borrow money,â€ť Cannataro said. Since itâ€™s not tied to an asset, interest rates on personal loans are generally higher than those on mortgages or car loans.
And because the rates vary from lender to lender, borrowers who sign on the dotted line without shopping around first are probably leaving money on the table. Just like you would compare multiple mortgage options or car loans, you should compare several personal loan offers.
But the loan with the lowest rate isnâ€™t automatically the best deal. Other fees associated with the loan contribute to the total cost, which is reflected in the loanâ€™s APR. Be sure to look at multiple personal loan options and review the APR of each for a more accurate comparison.
Most consumers know that before applying for a mortgage or car loan, they should check their credit. The same goes for a personal loan.
Your credit history will play a factor in the interest rate you get â€” and ultimately, how much your loan will cost you â€” so itâ€™s in your best interest to know whatâ€™s in your report before a potential lender takes a look.
Between incorrect account balances, mixed up identities and other mistakes, approximately 20 percent of consumers have an error on their credit report, according to the latest study by the Federal Trade Commission. An old account with negative marks could cost you thousands of dollars over the life of your loan.
Checking your credit will give you a chance to address any errors or outdated accounts that could cause you to get a less-than-ideal interest rate.
As we already covered, the interest rate on a personal loan is an essential factor since it determines the total cost of borrowing. But the rate isnâ€™t the only thing to consider when looking at interest.
How often the compound interest is calculated â€” whether daily, monthly, semiannually or annually â€” also affects the total amount of interest youâ€™ll pay over the life of the loan. Compound interest is when the interest that youâ€™re charged also accumulates interest.
â€śTypically, lenders spell out the total interest paid over the life of the loan,â€ť Cannataro explained. He said consumers should review those details carefully as they comparison shop.
In the example below, we compare the same loan amount and term with the compound interest calculated differently. As you can see, the more often the interest compounds, the more interest accumulates.
|Amount borrowed||Loan term||Rate||Compounds||Total loan cost|
Itâ€™s tempting to just think about the monthly payment when considering a loan. But so much more goes into the terms of a loan than how much youâ€™re dishing out every month. Overlooking those other terms can mean youâ€™ll end up paying a lot more than you planned to.
In many cases, loans with very low-interest rates could have high fees, so it is in your best interest to know what your lender charges.
Besides the interest rate and how it is calculated, here are some other terms and fees to look out for.
This is an upfront fee some lenders charge for funding or â€śoriginatingâ€ť the loan. It varies by lender but itâ€™s typically a percentage of the loan amount thatâ€™s often deducted from the principal of the loan or financed in addition to the amount borrowed.
This can add a significant amount to the loan depending on what your lender charges. For example, a 1-percent origination fee on a $10,000 loan is $100, while a 5-percent origination fee is $500.
Being able to pay off your personal loan early is a good thing, as it cuts down on the amount of interest you end up paying. However, it also eats into a lenderâ€™s expected profit. To offset that, some creditors charge a prepayment penalty.
This is something you should find out up front, even if you donâ€™t expect to pay off the loan ahead of schedule. Should you receive an unexpected bonus or want to pay off the debt early for any other reason, it will cost you to do so.
You may not intend to pay your loan late, but sometimes life has other plans. Find out what your lender will charge if you miss a payment.
Some lenders charge a fee just to process your application. In most cases, this fee is nonrefundable, so youâ€™ll lose your money if your application is denied.
If your loan payment is returned by your bank because of insufficient fees, your lender could charge you a hefty fee in addition to what your bank charges.
The monthly payment is not only related to the interest rate, but also to the length of the loan. Extending the life of the loan can make it more affordable monthly, but doing so makes the loan more expensive. â€śThe longer the loan, the lower the payment will be, but you have to consider how much interest youâ€™re paying,â€ť Cannataro cautioned.
Most consumers donâ€™t think to negotiate the terms of personal loans when shopping, but Cannataro said borrowers can use the internet as a tool to help them get a more favorable loan, especially if they bank locally.
â€śGo online and do your homework. Know the average rate available,â€ť he advised. â€śHaving a relationship at your local bank or credit union is a plus because you can go in armed with information.â€ť
Some institutions will meet or beat the rate you present, he added.
Personal loans can be an effective way to tackle high-interest credit card debt or unpaid medical bills that are accruing interest and late fees. But if you pay off a credit card only to run up the balance again, then you defeat the purpose of taking out the personal loan in the first place.
Be sure to address overspending or other issues before using a personal loan to consolidate debt.
Unfortunately, consumers looking for personal loans can be an easy target for scammers, especially if you have no or poor credit.
If an interest rate is unusually low, youâ€™re guaranteed approval before applying, youâ€™re asked to make a payment before receiving the funds or the terms of the loan just seem too good to be true, then you may be dealing with a fraudulent creditor. Learn more about identifying and reporting scams.
A personal loan isnâ€™t free money any more than a student loan or mortgage is, so getting one you donâ€™t need is a mistake.
Cannataro said consumers should carefully review whether or not they truly need to take out a personal loan. â€śGo in with eyes open and assess all the risks,â€ť he said. Ask yourself if what you stand to gain is worth the risks involved, he added.
Often the answer to that question is â€śno,â€ť according to Cannataro, and if thatâ€™s case, another path should be pursued.
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