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Personal loans can provide you with money when you need it and if you have good credit, they can be less expensive than high-interest credit cards. But like other types of credit, a personal loan could be more of a financial headache than a solution if you aren’t doing your homework first.
That starts with knowing some of the key personal loan mistakes to avoid. If you’re interested in getting a personal loan, here are 10 of the biggest challenges to watch out for.
1. Assuming all personal loans are the same
Generally, a personal loan is a lump sum of money you borrow and pay back over time, with interest. But personal loans aren’t identical.
For instance, personal loans can be secured or unsecured. A secured personal loan requires some type of collateral while an unsecured loan does not. There are personal loans for people with good credit and bad credit personal loans for borrowers with less than perfect scores.
Personal loans can have fixed interest rates, meaning the rate stays the same over the life of the loan. Or they can have variable rates, meaning your rate could go up or down over time.
Some personal loans, such as debt consolidation loans, have a single purpose while other personal loans can be used to cover a wide range of expenses. Understanding these kinds of differences can help with narrowing down what kind of personal loan is right for you.
2. Settling for the first personal loan you find
When looking for a personal loan, it’s a mistake to assume the first one you come across is your best borrowing option. Jumping on the first loan offer without reviewing the rates, fees and terms could cost you money or lock you into payments that aren’t a good fit.
An easy way to avoid that is by getting free rate quotes from multiple lenders. Just be sure to find out whether getting a quote will trigger a hard pull of your credit report since that could hurt your credit score.
3. Closing old lines of credit
A personal loan could be a great option for consolidating high interest credit cards. If you’re zeroing out the balances on your cards it may be tempting to close them, but that could be a mistake.
That’s because credit utilization and credit age count toward 30% and 15% of your FICO credit score, respectively. Closing credit lines can shrink your available credit and potentially increase your credit utilization ratio, which could hurt your score. Likewise, shutting down older accounts can negatively affect your credit age and cost you credit score points.
4. Adding to your debt
Aside from shutting down zeroed out credit cards, there’s another mistake to watch out for when consolidating debt with a personal loan. Running up new balances on the cards you just consolidated and paid off with a loan can work against your credit score since it increases your credit utilization.
Not to mention, having to make personal loan payments and credit card payments can put strain on your budget. The more debt you have, the more at risk you may be of paying late or missing payments altogether.
5. Overlooking origination fees
Lenders can charge origination fees for personal loans. These fees cover the cost of processing the loan and can be a flat dollar amount or a percentage of the loan amount.
Overlooking these fees can be costly if a lender charges a steep origination fee. For example, a 5% origination fee on a $15,000 loan can add up to $750. And since these fees are usually taken out of the loan proceeds, you have to factor that in when deciding how much to borrow.
6. Ignoring your credit score
Your credit scores are important when taking out a personal loan because they can determine whether you’re able to get approved and the interest rates you’ll pay. So checking your credit report and scores before you borrow is an important step.
And you can’t afford to neglect your credit scores once you’ve been approved for a personal loan either. Making your payments on time, for example, is crucial to building and maintaining a positive credit history.
7. Borrowing money you can’t afford to pay back
One of the biggest personal loan mistakes is taking out too large of a loan. When you borrow money that you can’t afford to pay back, you risk defaulting on the payments which can lead to credit score damage.
Defaulting on a personal loan can also spell trouble if your lender takes collection actions against you. Collection accounts can do even more damage to your credit score than late payments. And if a lender decides to sue, that could open the door to a wage garnishment or bank account lien. So it’s best to think carefully about how much you can realistically afford to borrow and repay before getting a personal loan.
8. Opting for a long loan repayment term
When comparing personal loans, you may find some that are short-term while others give you more time to repay what you borrow.
Opting for a longer loan repayment term has its advantages, a lower monthly payment being one of them. That could be a boon to your budget but consider the trade-off, in terms of the total interest costs.
The longer it takes you to repay a loan, the more interest you’ll pay altogether. Choosing a shorter repayment term may mean a higher payment but you’ll save more money in the long run on interest charges.
9. Not reading the loan terms
Signing off on a personal loan agreement before reading the fine print is another mistake to avoid. Before accepting a personal loan offer, it’s important to understand what you’re borrowing, how that money has to be repaid and what you’ll pay.
Also, consider whether there are any penalties or added fees built into the loan agreement. Some personal loan lenders, for example, can charge a prepayment penalty if you decide to pay your loan off early. If you’re planning to accelerate your loan payoff, it’s important to know whether you’ll get hit with a fee for doing so.
10. Only comparing costs
Costs are definitely something to be aware of with a personal loan but it’s also important to consider other factors, such as what a personal loan can be used for. Depending on the lender, you may be able to use a personal loan to:
- Consolidate debt
- Pay for home repairs or renovations
- Fund a dream vacation
- Get caught up on medical bills or other everyday expenses
- Start a business
- Pay for a wedding
- Cover the costs of a move
It’s always good to check upfront with the lender to see what you can use a personal loan for. That can help you avoid wasting time pursuing a personal loan that doesn’t fit your needs.