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How to Avoid the 10 Most Common Personal Loan Mistakes

10 Personal Loan Mistakes to Avoid

Personal loans allow you to borrow money for any purpose, with fixed interest rates and terms. When used responsibly, they can be an affordable way to finance major expenses or consolidate high-interest debt. However, personal loans come with risks if not approached carefully. Avoid these 10 common personal loan mistakes to protect your finances and credit.

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How to Avoid the 10 Most Common Personal Loan Mistakes

1. Borrowing More Than You Need

One of the biggest mistakes is borrowing an excessive amount beyond what you require for your intended purpose. Reasons to avoid overborrowing include:

  • Greater debt burden – You have to repay every cent borrowed plus interest charges. A larger loan means higher total repayment costs.
  • Higher monthly payments – Lenders calculate your monthly payment amount based on factors like loan size. Bigger loans equate to higher monthly payments.
  • Greater interest costs – Interest accrues on principal amount borrowed. A $10,000 loan accrues more interest per month than a $5,000 loan.
  • Longer repayment terms – Overborrowing can extend the repayment timeline to keep payments affordable. But this results in paying more interest over the life of the loan.
  • Difficulty repaying – Having an unnecessarily large personal loan makes it harder to repay within your budget. This increases chances of defaulting.

Calculate your exact needs rather than rounding up. If the purpose is debt consolidation, tally up total outstanding balances. If financing a purchase, determine its precise cost. Build in a 10-20% buffer at most.

Resist temptations to borrow extra for nonessential purposes. Stick to the amount you prepared for based on your purpose, budget, and repayment ability.

2. Not Shopping Around for the Best Rates

Falling for the first loan offer you see is an expensive mistake. Different lenders offer a range of rates based on prevailing market conditions, their profit margins, and assessment of your creditworthiness.

Shop around and compare loan quotes from:

  • Banks – Large national banks, local community banks, and credit unions.
  • Online lenders – Companies like LendingTree, SoFi, Marcus, Lightstream, etc.
  • Peer-to-peer lenders – Websites like LendingClub and Prosper that match you to investors.
  • Retail lenders – Store financing from dealerships, jewelry stores, furniture outlets.

Get multiple personalized quotes based on your credit score, income, and requested loan amount. Case study:

Lender Interest Rate Origination Fee
Local Credit Union 7.99% $0
Marcus 10.99% $0
LendingClub 15.24% 1% of loan amount

While the credit union has the best rate, LendingClub approved a larger loan amount. Crunch the numbers to see total costs over the loan’s lifetime based on your situation.

Online lenders like LendingTree let you easily compare personalized loan offers from their network in one place. Never accept a rate without doing thorough market research first.

3. Ignoring Fees and Additional Costs

The interest rate alone doesn’t reflect the total cost of borrowing. Lenders often charge:

  • Origination fees
  • Application fees
  • Processing fees
  • Prepayment penalties
  • Late fees

These can add hundreds to thousands of dollars over the loan’s term.

When comparing lenders, look at:

  • The APR (Annual Percentage Rate), not just the interest rate. The APR incorporates fees.
  • Whether the lender charges origination fees or points upfront when you close the loan. If so, how much are they?
  • Any prepayment penalties involved if you pay off the balance early.

Read the fine print to identify hidden costs. Weigh origination fees versus interest rates to see which lender offers the lowest overall pricing.

You can also try negotiating with lenders to remove certain fees, especially if you have strong credit.

4. Applying with a Low Credit Score

Your credit score drastically affects personal loan terms offered:

Credit Score Interest Rate
760+ (Excellent) 5-10%
720-759 (Very good) 10-15%
680-719 (Good) 15-20%
620-679 (Fair) 20-25%
580-619 (Poor) 25-30%
<580 (Very Poor) May not qualify

Someone with “Fair” credit pays nearly double the interest rate compared to someone with “Excellent” credit, for the same personal loan.

Before applying, obtain free copies of your credit report and FICO score from sources like AnnualCreditReport.com and CreditKarma.

If your score needs work:

  • Pay down balances on revolving debts.
  • Correct any errors on your credit report.
  • Become an authorized user on someone else’s account.
  • Limit new credit inquiries.

Allow at least 3-6 months for your actions to improve your score before reapplying. A higher score saves substantially on interest charges.

5. Not Reading the Loan Agreement Thoroughly

Never sign a personal loan contract without scrutinizing the fine print first. Key points to understand:

  • Interest rate – Is it fixed or variable? What index is it tied to if variable?
  • APR – Includes fees; gives the true cost of borrowing.
  • Loan term – How many months or years you have to repay it.
  • Payment amounts – How much is due each period. Is there a grace period?
  • Payment dates – What day of the month are payments due? Weekly, biweekly, or monthly?
  • Prepayment policy – Charges for paying off balance early, or no charges.
  • Late payment fees – How much is charged for missing a payment?
  • Default clauses – What constitutes default and its consequences.

Scrutinize any unclear or unfavorable clauses before signing. Never let urgency or a smooth-talking lender rush you through this vital step.

6. Choosing an Overly Long Loan Term

Personal loan terms typically range from 1-7 years. A longer term seems attractive since it lowers your minimum monthly payment.

However, it also increases the total interest you pay over the loan’s lifespan.

For example:

  • 5 year loan = $265 monthly payment.
  • 3 year loan = $424 monthly payment.

The 5 year loan has lower monthly payments but accrues $1,824 more interest overall.

When choosing a term, find the shortest duration that your budget can afford each month. Use loan comparison calculators to estimate different scenarios.

The quicker you can pay off the principal, the less interest you pay over time. Try picking up side income to help you meet higher monthly payments on a shorter term if needed.

7. Using the Loan for Non-Essential Expenses

Personal loans allow flexibility in usage, but are best leveraged for major necessary expenditures like:

  • Debt consolidation
  • Medical bills
  • Home repairs and improvements
  • Vehicle purchases
  • Education costs
  • Moving expenses
  • Emergency costs
  • Weddings

Avoid taking out personal loans for:

  • Luxury vacations
  • Dining out
  • Entertainment and hobbies
  • New gadgets and electronics
  • Shopping sprees

These generate short-term satisfaction but long-term financial burden. A personal loan should improve your overall position, not dig you deeper into debt.

8. Missing Payments

Personal loans count as installment credit. This means on-time monthly payments are important to build your credit score.

Consequences of missing payments include:

  • Late fees, usually around 5% of the unpaid monthly amount. This adds up quickly.
  • Penalty APR, meaning a higher interest rate kicking in as punishment. You also lose any promotional interest rates.
  • Lower credit score due to your missed payment being reported to the credit bureaus. This can dent your score by up to 100 points.
  • Loan default if you miss enough consecutive payments. This wrecks your score by over 200 points. The lender can send the debt to collections or pursue legal action.

Avoid these scenarios by only borrowing what you know you can repay on schedule. Build in some wiggle room in your budget in case of financial surprises.

9. Not Considering Alternatives

Personal loans may not always be the best financing solution. Evaluate alternatives like:

  • Credit cards – Better for smaller short-term borrowing needs. Just be sure to pay the balance off in full each month.
  • HELOC – Home equity line of credit. Leverages your home equity instead of taking unsecured debt.
  • 401(k) loan – Borrows against your own retirement savings. Must be repaid to avoid penalties.
  • Employer advance – Some companies provide one-time salary advances or loans in emergencies.
  • Payment plans – For medical bills, tuition, or taxes owed. Arrange installments directly with the service provider.
  • Crowdfunding – Creating an online campaign through GoFundMe, Kickstarter, Indiegogo, etc.
  • Windfall – Tax refunds, gifts, bonuses, lawsuit settlements, insurance claims.

Crunch the numbers to see if one of these alternatives may provide cheaper financing for your situation.

10. Not Having a Loan Repayment Plan

Too many people take out personal loans without considering how they’ll fit the new monthly payments into their budget. That’s a recipe for missing payments and damaging your credit.

To avoid this, make a loan repayment plan that addresses:

  • How you will remind yourself of monthly due dates – automatic transfers, phone alerts, calendar reminders, etc.
  • What budget items you will reduce or cut out to make room for the new payment amount – dining out, entertainment, shopping budgets, etc.
  • Which other debts you will continue paying minimums on versus paying off completely.
  • Additional income sources you can tap into to supplement your regular income – freelancing, part-time jobs, monetizing skills/hobbies.
  • Backup options if you lose your job or face another financial emergency.

Continuously monitoring your budget and priorities helps protect your credit and ability to repay.

Key Takeaways

Personal loans offer convenient access to credit with predictable repayment schedules. But borrow irresponsibly, and they become burdens rather than solutions. By avoiding common mistakes like only checking one lender’s rates or borrowing more than required, you can make personal loans work in your financial favor.

FAQ

What credit score do I need for a good personal loan rate?

For the best personal loan rates, you typically need a minimum credit score in the mid-600s, though requirements vary by lender. Interest rates drastically improve once your score reaches the low 700s. Focus on improving your score before applying.

Should I take out a personal loan to invest in the stock market?

No, this is an extremely risky use of borrowed funds. The stock market’s returns are uncertain, but the loan must be repaid with interest regardless of your investment’s performance. Never take loans for speculative purposes.

Can I get my cosigner released from a personal loan?

Some lenders may release a cosigner if you make a certain number of on-time payments (usually 12-24 months). This depends on their policy. If they won’t release the cosigner, you’ll need to refinance the loan in your name only once you have the credit to qualify alone.

Should I use a personal loan or my credit card to finance a vacation?

A personal loan is better for a larger, pricier vacation since cards have lower limits and high variable rates. But avoid debt entirely for nonessential expenses if possible – save up instead. If you do finance a vacation, commit to rapid repayment.

Where can I get a personal loan with bad credit?

Those with credit scores below 580 will have difficulty qualifying for personal loans. Subprime lenders may approve you but charge very high rates. Instead, focus on credit repair first. Once your score reaches 600, more standard personal loan options open up.

ALSO SEE:

Financial Success: Avoid Loan Rejection and Boost Your Credit Score with These 12 Tips

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