Thursday, 27 January 2022

How Personal Loans Work and the Traps to Avoid

How Personal Loans Work and the Traps to Avoid
25 Sep

Young couple calculating their domestic bills

Updated September 24, 2018.

Credit cards shouldn’t be a default when you’re looking to borrow some money. Personal loans are not only simpler, but they offer better rates. Even better, you can shop for the best personal loan rates without hurting your credit score. For example, you can the LendingTree Personal Loan Shopping Tool to get prequalified in less than five minutes. (Note: LendingTree is the parent company of MagnifyMoney).

When you’re approved for a personal loan and accept the terms, the money can be sent directly to your bank account, or you can get the money by check.

Loan terms are usually pretty simple:

  1. There is a fixed term. You know when the debt is paid off, and it is almost always less than 5 years. (Pay the minimum due on your credit card, and you could still be paying 30 years from now). There usually aren’t pre-payment penalties, but some loans do have them, and you should check for that before you accept the loan.

  2. There is a fixed interest rate. Your monthly payment and interest rate stay the same for the life of your loan. Credit cards will increase the interest rate on your existing balance if you become 60 days past due. And they can increase your interest rate on future purchases at any time.

Personal loans aren’t without their faults

Even personal loans can have their own tricks. While we like them better than borrowing with credit cards, you need to watch out for:

  1. Insurance sold with the loan.

  2. Pre-computed interest

  3. The origination fee

  4. Pre-payment penalties

Oddly enough, these tricks might not be buried in fine print. In fact, your insurance salesman might mention a few to convince you they’re necessary for your protection. We want you to understand what these four terms mean so you can decide if you need them, and if you do, how to find options that won’t cost you hundreds or thousands in extra fees.

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How To Avoid The Tricks

There are a number of lenders out there that do not bundle insurance, do not use pre-compute interest contracts, do not charge an origination fee and do not have pre-payment penalties.

We recommend you shop online to find lenders without those tricks and traps. A good place to start the search is with LendingTree, our parent company. With one, short online form LendingTree will perform a soft credit pull (with no impact to your score) and match you with multiple loan offers. Interest rates can be below 6% for people with excellent credit. And because dozens of lenders participate in LendingTree’s program, you may also find lenders willing to accept borrowers with less than perfect credit.



Credit Req.

Minimum 500 FICO

Minimum Credit Score


24 to 60


Origination Fee


LendingTree is our parent company.Read More

Now we will explain, in more detail, the tricks that you can find hidden in some personal loan contracts.

Trick One: Insurance

We all want to protect our families from the unexpected and insurance is a great way to do just that.  Similar to how we recommend planning in advance for your debt (and looking for the best deal), you should do the same with insurance. However, many personal loan providers will try to add an insurance sales pitch at the end of a loan closing.  The two most typical types of insurance are life insurance and unemployment insurance.

For life insurance, a typical sales pitch would sound like this: “for just the cost of a can of soda a day, you can make sure you children never have to worry about this debt if you die.” Beware these high-pressure sales tactics.  The value of these add-on policies is almost always outrageously bad.

To protect your family, you should think about a good term life insurance policy that covers not just your personal loan, but all of your needs.  Do this search separate from the loan transaction.

Unemployment insurance could be a bit more compelling (because, unlike term life insurance, it is difficult to buy a policy separately that would make loan payments on your behalf if you lose your job).  I have seen people benefit from these policies.  But you need to do the math.  How much does it cost per month?  So long as you don’t have a high risk of losing your job in the next 6-12 months, you are almost always better off saving the money (rather than paying the premium).  There are also a ton of limitations to the amount of the loan payment that can be made (and the length of time that it will be paid).  You should ask them the following questions:

  1. How much does this cost a month?

  2. What are the requirements for me to be able to claim?

  3. How much would it pay and for how long?

When you ask those questions, you will likely see that the policy being offered is poor value, and you are better to just save the money yourself.

Trick Two: Pre-Compute Interest

This one is a bit confusing. So, we will make it simple. Pre-compute interest is a bad deal.  Avoid it. And don’t be afraid to ask if it is being done to you.

It is a complex way of calculating interest – and the entire reason it exists is to make sure that you pay more interest in the early months/years of your loan. So, if you pay off your loan early, you will end up paying a higher interest rate than the rate quoted.

If you take out a loan with a three year term, and you take the full three years to pay back the loan, then there is no difference between a normal loan and a pre-compute loan.  But, if you pay off the loan early, then you will pay more interest.  Advertising is particularly misleading if there is a promise of “no prepayment penalty” because interest is charged according to the “precompute” method.

How does precomputed interest work?

In a normal loan, interest will accrue every day at the agreed rate. If you want to pay off your balance, then you just need to pay back the balance of the loan and any interest that has accrued since your last payment. Simple.

In a pre-compute loan, the total amount of interest that you would pay during the entire term of the loan is calculated and added to the balance up front. So, if you borrow $100, and you will pay back $50 of interest during the loan – then your balance becomes $150.  If you pay off your balance early, then an interest refund is calculated. The interest refund is calcuated using the Rule of 78. This is yet another complicated way to make sure you are charged more interest up-front. If you want to learn how the calculation works, visit this site.

Bottom line: don’t be afraid to ask if they calculate interest using the “pre-compute” method. If they do – don’t be afraid to walk away. Especially if you think you are going to pay off the loan early.

Trick Three: Origination Fee

Most personal loans charge an origination fee – so there is really no avoiding it. To see if you are getting a good deal, make sure you compare the APR of a loan, not the interest rate.  An APR includes the origination fee, and it assumes that you do not pay off the loan early.

There are 2 ways that people get stuck with the fee:

  1. You don’t realize the fee is deducted from the loan amount.  If you need to borrow $10,000 and there is a 3% fee, then make sure you borrow $10,309.28.  The 3% fee would be deducted and you would end up with $10,000 of loan proceeds.

  2. You don’t get a refund if you pre-pay.  In the example above, if you paid off your loan one day later, you would not get the fee refunded.  So an origination fee is like a disguised prepayment penalty.

The APR of a personal loan (including the fee and interest rate) can be well below a credit card interest rate (and it can save you a lot of money).  Just make sure you understand the fee and compare the APR.

Trick Four: Prepayment Penalties

There are indirect ways of charging a prepayment penalties (pre-compute interest and origination fees).  And then there are direct ways: a prepayment penalty.  Most lenders do not charge this, so you should be able to avoid it completely. Just make sure you ask if there is a prepayment penalty.

Personal loans are great, if you do the research

With a personal loan, you can have a fixed interest rate, fixed payment and fixed term.

If you compare APRs, then you will be making the right decision. Don’t just jump into picking a personal loan and end up taking out a pre-compute loan, with three add-on insurance policies and a big origination fee – only to refinance the loan three months later.  These are sub-prime tricks that can dramatically increase the costs.

If you borrow for 36 months and pay it off in 36 months, then you are in good shape.


Advertiser Disclosure: The card offers that appear on this site are from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all card companies or all card offers available in the marketplace.

Nick Clements


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