A strategic loan can be a catapult into the next financial stratosphere. However, a bad loan can be an albatross, leading to psychological and financial ruin and even bankruptcy.
Accepting a loan should never be taken lightly. While you may be looking into a loan because of the potential upside of a cash infusion, recognizing the pitfalls of bad loans is even more critical.
By considering the most detrimental mistakes other borrowers have made, you can secure a loan (or choose not to take one at all) without the financial regret so many have suffered.
1. Borrowing More Than You Can Pay Back
For those who don't truly understand the term “risk,” the prospect of tens or hundreds of thousands of dollars is too much to turn down. Terms like “10% interest” and “repossession” are easy to dismiss when easy cash is on the table.
In most circumstances, loans should be a last resort for most. Large debts are usually to be avoided unless you are financially secure and confident you can pay the loan back no matter what.
2. Borrowing Money for Depreciating Assets
One of the primary differences between good and bad debt is the reason you are using the borrowed funds.
Going into debt for a car that loses value when it leaves the lot is bad debt. Going into debt to invest in a business is possibly good debt. If you seek a loan for any asset with depreciating value, there's a strong chance you're making a mistake.
3. Applying for the Loan When Your Credit Score Is Suboptimal
Though other factors come into play, the worse your credit score is, the less favorable loan terms will be. Therefore, even if your need for capital is pressing, it's worth taking steps to boost your credit score before applying for a loan.
The minimum credit score for a traditional loan is 620, but you should probably shoot higher than the minimum. Look for the weak spots in your score (like an insufficient credit mix), address them immediately, and then begin exploring loan opportunities.
4. Failing to Account for Fees and Hidden Charges
Most loans have fees. Disbursement fees, insurance fees, early repayment fees, and servicing fees should all be considered before you sign anything.
While most borrowers pay the greatest attention to interest rates, principal, terms, fees, and other hidden costs are just as important. You can only know the actual cost of borrowing if you know every associated fee and charge.
5. Accepting the First Loan You Apply For
Like any financial investment, shopping around is the key to finding a deal and avoiding unnecessary losses. Loans are no different. As exciting as it can be to get approval for a loan (at a seemingly reasonable interest rate), failing to compare other offers constitutes financial negligence.
See what other offers are out there before agreeing to any loan terms.
6. Failing to Prequalify Before Applying
Prequalification is the step before formally applying for a loan. Like a coffee date before taking a dating partner to a five-star restaurant, prequalification can spare you wasted time and headaches down the line.
You can provide basic personal and financial information to lenders to get a preview of likely loan terms. This can help you narrow down the lenders with whom you might fill out a formal application.
7. Cosigning for Someone You Shouldn't
Cosigning has long been a way for friends and loved ones to help out their less creditworthy compatriots. However, cosigners should never sign on for someone they're not confident will honor their obligations.
Rather than letting guilt tactics or emotions get the best of you, make a cold, hard, ruthlessly objective analysis of whether your co-signature could leave you holding a large financial debt.
8. Downplaying a High Interest Rate
Interest rates are among the most common criteria for deciding whether to accept a loan. Those in dire financial straits or lacking the necessary financial discipline may rationalize a high interest rate in many ways.
Let those who have spent years (or decades) handing over massive interest payments serve as cautionary tales. If the interest rate is higher than you can afford or justify, just say no to the lender.
9. Not Autopaying
Life is too hectic not to use autopay for your loans. Missing four consecutive mortgage payments could trigger foreclosure, while there are similarly draconian consequences if you miss payments on other debts.
If you were to have a serious health event or other circumstances take your attention away from paying bills, autopay could be your saving grace.
10. Not Having a Financial Professional Overlook the Terms
Loan terms and conditions are dense, and for good reason. There are countless considerations beyond the term and interest rate to weigh.
Particularly if you are looking at a high-value loan, it's often worth having a financially savvy professional review the terms before you sign the paperwork. This one-time expense (or favor from your lawyer cousin) could spare you from a serious financial mistake.
11. Taking Out a Variable Rate Loan
Loans with fixed interest rates are fairly self-explanatory. You sign up for specific terms, which generally apply throughout the life of the loan.
Variable-rate loans, on the other hand, change terms based on prevailing interest rates. These types of loans have led countless borrowers to lose their homes and suffer other catastrophic consequences. Be wary of these loans unless unique personal circumstances make them suitable for you.
12. Taking out a Loan when your Professional Future is in Doubt
As a general rule, the less debt you maintain, the better off you'll be – no matter what credit-rating services might tell you. Few situations are more precarious than having high debt obligations when you lose a job, or your earning power unexpectedly declines.
Unless you have other options, taking out a loan during a time of professional uncertainty is a recipe for repossession, foreclosure, and bankruptcy.
13. Not Understanding the Ramifications of Defaulting
By and large, Americans are too casual about going deep into debt. This implies a lack of understanding of how catastrophic defaulting can be.
Late loan payments can sink your credit score by as much as 100 points. A default also plagues your credit record for up to seven years, meaning you'll be far less likely to secure future credit, and if you do, you'll face interest rates likely to sink you into further financial hardship.
14. Accepting a Long-Term Loan in Favor of Lower Monthly Payments
You want to strike a favorable balance between reasonable monthly payments and loan terms. Too often, borrowers elect for lower monthly payments, not realizing they will ultimately pay more total interest because of an extended loan term.
Though you want to be sure you can afford the monthly loan bill, if you elect for a longer term, you'll be in debt for longer and likely face a higher interest rate.
15. Failing to Research the Lender
Not all lenders have equivalent scruples. Some lenders are known for predatory interest rates and other shady practices.
Extensively researching a lender's reputation is a must for any prospective borrower. Some lenders have even been branded as scammers. Consulting the Better Business Bureau (BBB) and the Consumer Finance Protection Bureau (CFPB) are two ways to avoid being locked into a contract with a predatory lender.
16. Not Asking Enough Questions About the Loan
We sometimes feel asking questions makes us a burden. However, if you're considering taking out a loan, you owe it to yourself to pepper the lender with questions.
Fees, prepayment penalties, loan terms, and variable versus fixed rates are among the topics to address. Here is a more comprehensive list of questions to pose before signing on the dotted line.
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