Good credit depends, in part on having a healthy mix of loans that you can handle successfullyâsomething like a mortgage, auto loan, and a small credit card balance would boost your credit mix and help you establish your creditworthiness.
There are some loans, however, that should never be part of your credit mix. Even though it might be appropriate to borrow to own a home or have reliable transportation, not all borrowing has an upside. Here are six types of loans you should never get:
Loans taken out against your 401(k)-retirement account may seem like an easy route to take, but you should consider other options first because they attack the retirement savings youâve worked very hard to build up.
Itâs true that 401(k) loans carry a relatively low interest rate and are tax-free money, but you repay the loan with after-tax dollars, all while you are losing out on the earnings those retirement funds are supposed to be accumulating for you.
If you lose your job either through a layoff, furlough, or a voluntary resignation, most plans require that you pay off the loan within a short period of time, typically 60 days. In the unfortunate event, you canât repay the loan, it gets more complicated. In this case, the money you took out is considered a hardship distribution, and you will be required to pay taxes on the unpaid balance and an early withdrawal fee.
There are some experts who can show you the math that makes 401(k) loans look better than other options, but you should not thoughtlessly listen to them. The money you pull together to repay this kind of loan could have earned more for you if you had contributed it to your retirement account rather than used it to get out of the hole the debt created.
Payday loans are usually small, averaging under $500. These kinds of loans are repaid with one payment, usually within two weeks to one month of when the loan was given. On âpaydayâ, you are expected to pay back the loan in full. If you have a regular income, whether through a job, social security check, or pension, you can get one of these loans (assuming they are legal in your state).
These loans are very expensive, but in a deceptive way. Typically, one of these loans might come with a fee of $15 to $30 for every $100 borrowed. Because the cost is fixed in this way, people donât think of it in terms of an annual percentage rate (APR). If you calculate it compared to traditional loans, the APR for a payday loan is near 400% or higher. Shorter-term Loans have even higher APRs. Rates are higher in states that do not cap the maximum cost.
How could that be, if youâre only paying a fee of $15 for every $100 borrowed? Isnât that 15%? Itâs because payday loans have a very short repayment schedule relative to other loans. If you borrowed $100 by shopping with a traditional credit card and paid it off within 2-4 weeks like a payday loan, youâd probably pay no fees or interest due to grace periods. And if you took a full year to pay it off, youâd pay around 15% APR, not 400% like a payday loan.
Taking out a loan is often necessary, whether it’s for a car, home, education, or other major expense. But not all loans are created equal. Some come with reasonable interest rates and terms, while others can trap borrowers in a never-ending cycle of debt. So what is the riskiest type of loan that borrowers should avoid?
Understanding High-Risk Loans
In the lending world, “high-risk loans” refer to loans given to borrowers with poor credit or limited credit history. These borrowers are seen as riskier by lenders because they have a higher likelihood of defaulting on the loan. As a result, high-risk loans tend to come with:
- Sky-high interest rates – often 20% or higher
- Large origination fees or prepayment penalties
- Short repayment terms – often only weeks or months
- Strict late fees and penalties
- Low loan amounts
These terms are intended to offset the risk of lending to borrowers with questionable finances But in reality, the terms often create a debt trap, making it very difficult for borrowers to successfully repay high-risk loans
Some examples of common high-risk loan types include
Payday Loans
Payday loans provide fast cash – often $500 or less – that must be repaid on the borrower’s next payday. Hence the name. They come with exorbitant fees, equating to APRs of 400% or more in many cases. And if borrowers can’t repay by their next paycheck, the debt grows rapidly.
Car Title Loans
These loans allow borrowers to use their paid-off car as collateral But they come with sky-high interest rates and short 30-day repayment terms About 1 in 5 borrowers have their car seized when they can’t repay the loans.
High-Interest Personal Loans
While easier to qualify for than standard bank loans, these personal loans come with interest rates frequently exceeding 30%. And they often have inflexible repayment terms that set borrowers up to fail.
Payday Alternative Loans (PALs)
Offered by credit unions, PALs are a more affordable alternative to payday loans. But even their interest rate cap of 28% keeps them in the “high-risk” category.
Bad Credit Debt Consolidation Loans
These loans roll high-interest debts into a single loan with lower monthly payments. But borrowers with low credit still pay sky-high interest, often 20% or more.
The Risks of High-Risk Loans
It’s easy to see the appeal of quick cash offered by high-risk lenders. But these loans ultimately do more harm than good in most cases. Consider the risks:
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Debt spirals – Unaffordable payments and stacking fees lead to a never-ending debt cycle.
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Losing assets – Defaulting on car title loans or home equity loans can lead to your assets being seized.
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Damaged credit – Late payments will further sink already-poor credit scores.
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Bankruptcy – If high-risk debt becomes unmanageable, bankruptcy may feel like the only option.
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Stress – Debt problems take a toll on mental health and relationships.
While these loans provide short-term relief, they are almost never worth the long-term financial damage.
What Is the Riskiest Loan Type?
So what is the single riskiest type of high-risk loan to absolutely avoid? Payday loans take the crown here. With APRs averaging 400%, payday loans are designed to bury borrowers in debt. Even the Consumer Financial Protection Bureau warns they “set up consumers to fail.” Steer very clear of payday loans whenever possible.
Car title and payday alternative loans can also be debt traps given their ultra-high rates and short repayment terms. Bad credit personal loans may be safer than payday loans, but their high rates still pose risks.
Alternatives to High-Risk Loans
The good news is safer borrowing alternatives do exist, even for borrowers with poor credit. Options to avoid high-risk debt include:
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Credit counseling – Nonprofit credit counseling provides advice on improving your finances and navigating debt. Many services are low cost or even free.
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Debt management plans – Credit counseling agencies can set up Debt Management Plans to consolidate debts into one payment with reduced interest rates.
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Borrowing from family or friends – For some, borrowing from family or friends is possible with clear terms and expectations. Be sure to put any agreements in writing.
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Secured credit cards – These cards require a security deposit that becomes your credit limit. Making on-time payments builds your credit.
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Federal student loans – Government student loans generally offer reasonable rates and flexible repayment options.
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401(k) loans – Loans against a portion of your 401(k) balance may provide affordable financing if paid back promptly.
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Credit-builder loans – These loans report on-time payments to credit bureaus to help build your credit score.
The bottom line is avoiding super-high interest rates is key to avoiding dangerous debt spirals. While no borrowing option is risk-free, the alternatives above provide safer ways to access funds during challenging times.
Steer Clear of the Debt Trap
High-interest, high-risk loans rarely end well for borrowers. Payday loans are by far the riskiest, but car title loans and payday alternative loans can trap borrowers too. If you have bad credit and need funds, spend time reviewing safer alternatives that won’t bury you further in debt. Your financial future is worth the extra effort to avoid a high-risk loan’s debt spiral.
Personal Loans from Family
It should be obvious how many ways this kind of loan can go wrong. When you borrow from your loved ones, your failure to repay can damage the most important relationships in your life.
Worse, itâs more likely youâll fail to repay because your family members will be unlikely to pursue collections as aggressively as a traditional lender. That leads to lax repayment schedules, which only increase tension.
In the age of social media, your family will probably see pictures of you online where you are enjoying yourself. Every vacation you take, every concert you go to, every activity that people like to document and share will be a trigger for the people who loaned you money. Think very carefully about how you would feel if you had loaned any of your friends and family money based on their online presence.
If you are considering borrowing money from a family member, stop and assess your situation. Have you reached the point of desperation where you see no choice but to risk your relationship by asking for money? What got you into this kind of financial trouble? Doesnât your family member deserve to know, before they give you the funds?
If what you need the money for is too embarrassing or difficult to talk about with family, then itâs a bad idea to ask them for this loan. Address the root causes of your financial situation, rather than applying a band-aid in the form of more debt.
If youâre thinking of getting one of these kinds of loans, talk to a debt counselor first, and see if thereâs a better solution. Work to pay off your existing debts and build good credit so you have access to reputable loan products at reasonable rates. Donât put your home, car, retirement, or family relationships at risk when there are better ways to reach your financial goals.
âMelinda OppermanArticle written byMelinda Opperman is an exceptional educator who lives and breathes the creation and implementation of innovative ways to motivate and educate community members and students about financial literacy. Melinda joined credit.org in 2003 and has over two decades of experience in the industry.
Home Equity Loans for Debt Consolidation
This is a tricky one, because home equity loansâwhere you borrow against the part of your home that you have paid offâmay be a good idea for home improvements, but you should avoid them for debt consolidation.
You work hard over many years to build up the asset that is your home, and cashing in those funds is something that should be done with great care. Typically, the only time youâll cash in on home equity is when you sell the home and put that money into the next home you buy.
There are some cases where you might get a home equity loan and use that money to improve your property. This can make good financial sense if the property increases in value more than the amount you borrowed against your home equity. As a bonus, if you use home equity loans or a Home Equity Line of Credit (HELOC) to substantially improve your home, the interest paid on that loan is tax deductible.
What doesnât make financial sense is paying off credit card debt using equity from your home. People do it because home equity loans are less expensive than credit cards, and they can usually pay off a lot of debt with one big home equity loan. This gathers a lot of small debt payments into one larger monthly payment at a lower interest rate.
That said, this seldom works out. Once people pay off their credit cards, they are free to use them, all while trying to pay off their home equity loan. They end up needing credit counseling because theyâve given up their ownership of their home and still end up with credit card debt.
Our advice is to never trade good debt for bad. Mortgages are âgoodâ debt, in that they help you build wealth over time. Donât use a good debt like a home loan to pay off âbadâ debts like credit cards.
Related Articles: Good Debt Vs. Bad Debt
The worst-case scenario is one where you canât afford to repay the home equity loan and you end up having to sell your house or lose it to foreclosure. Donât ever put yourself into that positionânever borrow against your home equity unless those funds are earmarked to make the home worth more money.
An auto title loan lets you borrow in the short term by putting the title to your car up as collateral. Like payday loans, these loans are short-term and have a very high APR. And like home equity loans, you cash in on an assetâin this case, your carâin exchange for quick funds.
The risk is great, as you can lose your car if you donât repay as agreed. Even worse, people can lose their car for an amount much lower than the carâs value. The Consumer Federation of America report cited above, it states that half of car title loans are for $500 or less and come with an average APR of 300%. Tens of thousands of cars are repossessed every year because of these small loans.
We stress the importance of preserving your ability to earn an income, so if you need a reliable car to get to work, an auto loan is warranted. But getting a title loan against a car you already own is the oppositeâitâs risking an important asset for a short-term infusion of cash at very bad terms.
You use credit cards to make purchases, so why not use them to get cash? Because itâs a terrible idea. Cash advances arenât like withdrawing money from the bank. This is a loan, and one that is very expensive and too easy to get.
If you get a cash advance, youâll be charged a fee upfront, typically up to 8% percent of the amount you borrow. Then you pay interest on the debt that is higher than the regular interest rate for credit card transactions. On average, the interest rate for cash advance balances is around 7% higher than the normal rate for purchases.
The downsides donât stop there. Cash advances donât have a grace period like purchases doâyouâll start paying that extra-high interest from day one until you pay off that balance.
You typically get cash advances using an ATM, but those checks that your credit card company sometimes sends you are the same loan product, and carry the same bad terms. Shred those checks immediately when you get them, and donât get a cash advance through your credit card company for any reason.
How Does Interest Rate Risk Differ Between Various Loan Types? – BusinessGuide360.com
FAQ
Which loan is the riskiest type of loan?
- 401(k) Loans. …
- Payday Loans. …
- Home Equity Loans for Debt Consolidation. …
- Title Loans. …
- Cash Advances. …
- Personal Loans from Family.
Which loan is high-risk?
In simple words, the credit extended to those borrowers who have low credit scores, or unsecured loans is called high-risk loans. Usually, it is the unsecured loans such as personal loans that come under this category.
What kind of loan should you avoid?
Title loans allow you to borrow money by using your car as collateral. If you fail to repay the loan, the lender can take your car. Reasons to Avoid: Risk of Losing Your Car: The biggest risk is losing your vehicle if you can’t repay the loan on time, which can be devastating if you rely on your car for transportation.
What is considered a risky loan?
A high-risk loan will usually have a high interest rate, short repayment term, collateral requirements and a relatively low loan amount.Mar 22, 2024
What is the riskiest loan type?
Because credit cards are accessible to just about anyone, even people with low credit scores, they tend to be the riskiest types of loans that banks make.
What makes a loan a high risk loan?
A high-risk loan will usually have a high interest rate, short repayment term, collateral requirements and a relatively low loan amount. Lenders will typically forego a credit check and approve a loan based on a borrower’s income or other borrower qualifications. Which loan has the highest risk?
What is a high risk business loan?
High-risk business loans are typically small business loans that are offered to businesses with poor or little credit. (Video) Payday Loans: The WORST Type of DEBT, Pay This Off Right NOW! What are high risk loans quizlet? Perhaps the most common examples of high-risk loans are those issued to individuals without a strong credit rating.
What are examples of high-risk loans?
Perhaps the most common examples of high-risk loans are those issued to individuals without a strong credit rating. High-risk lenders may consider a variety of factors in making such a loan and setting the terms: Income and ability to pay: Lenders compare a borrower’s annual income to the amount of money desired.
What is the interest rate on a high-risk loan?
However, the interest rates on other high-risk loans – bad credit, payday, title – generally are much, much higher, sometimes 300% to 400% or more. Here’s the rub: The lower your income and credit score, the higher the interest rate on a high-risk loan is likely to be.
Is a payday loan a risky loan?
Unsecured loans are the riskiest for lenders to approve, because the lender doesn’t require collateral for reclaiming their lost funds if the borrower defaults. Payday loans don’t require collateral but can charge an exorbitant interest rate and extremely high fees. What credit score is considered a risk?