Which loans should you avoid? – that will be the topic of today’s article.
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Table of Contents
Loans are crucial to us when we want to handle our financial situations in a proper way.
Some people are fortunate enough to avoid loans throughout their entire lives.
Their previous generations may have left a significant amount of wealth for them.
Otherwise, they might have worked hard enough to create their wealth.
This situation applies to very few people, and the scenario is different for many individuals.
Not everyone gets the opportunity to create their own wealth, even if they work hard.
At the same time, many individuals don’t have wealthy parents or grandparents.
This creates such a situation where a person would seek a loan from a financial institution.
There are many reasons for a person to intend to get a loan, and some of the most common ones are:
— Debt consolidation
— Property remodelling
— Moving to another place
— Unexpected expenses
— Large purchases
In most of these situations, a personal loan should allow you to meet your financial needs.
Not all personal loans come with an APR that suits you or the amount you desired for.
Sometimes, the situation comes in such a way that you might have to pay higher APRs.
APR, short for Annual Percentage Rate, is the annual interest paid by the borrowers to the lenders.
Furthermore, when may or may not meet the lender’s criteria for a loan. In such scenarios, people often seek loans without paying attention to the interest rates.
This means they try to get a loan even if the APRs are comparatively higher than normal.
Such loans would need the borrower to pay a lot of money in terms of interest, leading to a financial loss.
Today, I will shed some light on some loan types that you’ll need to avoid.
Unless it’s an emergency, you should always stay away from the loan types that we are about to discuss.
Let us begin.
Loans against Retirement Accounts
In some parts of the world, such as the U.S., lenders offer loans against an individual’s retirement account.
This refers to a loan being offered based on retirement funds as collateral.
Retirement funds are supposed to allow you to secure your retirement by saving up for it.
This generally includes the tax-deducted money that is contributed from the beginning of your employment.
Retirement loans, such as 401(k) loans, come with certain benefits such as low APRs. There may even be a possibility for you to get this amount without incurring taxes.
The process of getting such retirement loans is also straightforward.
So, what’s the harm in taking a loan against your retirement anyway? There are a few ways in which you’ll be affected, which have been described below.
First, individuals have to repay the tax-free amount they borrow with taxed income.
In most cases, taking a loan against your retirement will have conditions on the loan amount. In the U.S., you can only borrow half of your amount in your retirement savings (up to $50,000).
Those who already took a loan from their retirement savings may only get access to lesser loan amounts.
If you leave the company you’re working for, the lender will ask you to pay the balance in full.
The loan comes with a short tenure, such as five years, which might be somewhat inconvenient.
However, in the U.S., a loan acquired to purchase a primary residence is available for a longer term.
Another huge drawback is not being able to maintain enough funds for your retirement savings.
Yes, the loan is temporary and you’ll pay it back within a brief period. Nonetheless, you will miss out on the investment returns that could have been acquired.
No matter how feasible a retirement loan looks, you should always consider these aspects.
Effective tips for repayment
— Make timely repayments. Usually, the loan dues get deducted from your salary before you receive them. It is generally a great way to avoid falling back on making timely repayments.
— Plan for a repayment schedule based on your financial situation. Adding the repayment schedule to your budget will help you make things easy.
— There are prepayment penalties with most retirement loans, regardless of the country. So, try to pay off the loan earlier so that you won’t miss out on the investment returns.
— Some people find it hard to make repayments after leaving their job. If so, you can always get another loan from your new employer to repay the loan.
— There is an effective way to avoid the issue discussed above. This is by paying off the existing retirement loan before leaving your job.
In the United States alone, it is estimated that around 12 million people opt for payday loans.
This is mainly because of the easy accessibility and availability of many lenders.
Payday loans look very advantageous when someone is looking for an emergency expense.
Wait, there’s still more. The amount that can be acquired with a payday loan is often very little. For instance, payday loans in the US are available up to an average of $500.
How’s a small loan of $500 going to affect you negatively, right?
Well, payday loans are available at extremely high interest rates. The period offered for the repayment is also quite low compared to other loans.
Additionally, these are to be paid in a lump sum amount when you receive your salary.
Just to state as an example, payday loans come with APRs up to 400%, which is huge.
The fee might look too deceptive, often with up to $30 on every $100 borrowed. Nonetheless, if you compare them with traditional loans, this will amount to an APR of up to 400%.
With most lenders, you will have to pay back the loan amount within as little as two days.
People who can’t be able to make the payment in time will often seek another loan to repay this. This will lead to a situation where the individual would be subject to a debt cycle.
The lenders may also go for inconvenient collection methods in an event of failing to repay. This would seem as if the debt collection process were somewhat pestering.
Effective tips for repayment
Given below are certain steps on how you can pay back payday loans wisely.
— Always find out about the costs involved with the payday loan you choose.
You won’t likely get them at APRs lower than personal loans or credit cards. Nevertheless, you can find some competitive rates for payday loans if you shop around enough.
— If possible, try choosing an alternative method such as a personal loan. By maintaining a good credit history, you will be eligible for such loans with lower rates.
These types of loans often come with reasonable repayment terms, which won’t become a burden for the borrower.
— You could also get a loan for a substantially lower interest rate to pay back the payday loan.
— Debt collectors aren’t allowed to harass you when you fail to make a timely repayment.
In the US, the Fair Debt Collection Practices Act restricts making calls except from 8 AM to 9 PM.
Important information: Most borrowers who get a payday loan usually end up defaulting on their loan.
This can happen during the first year itself when they acquire such a loan.
There are even possibilities for such borrowers to end up in a debt cycle or default on other loans.
What I suggest is to avoid payday loans once and for all. Never get a payday loan. I say never.
The majority of people have something valuable with them such as an expensive watch or jewellery.
Such people tend to get a loan by keeping those items as collateral during an emergency.
These types of loans are offered by pawn shops and are known as pawnshop loans.
Pawn shops offer loans on various things like jewellery, smartphones, laptops, etc.
The amount you get with pawnshop loans is solely dependent on the value of the item.
In most cases, the amount will not even be close to the actual value of the item.
Like payday loans, pawnshop loans also come with fewer requirements, making them lucrative.
No credit score requirements. No need for income proof. What else does a borrower need, especially during an emergency?
All you need to do is verify that you are the rightful owner of the item being pawned.
After everything looks good, you’ll get a loan agreement along with details on the repayment schedule.
The loan amount offered by a pawnshop would range between 25% to 60% of the resale value.
The interest rates are usually up to 25% a month, which may lead to an APR of more than 200%.
Some regions have certain restrictions on the maximum interest rate on a pawnshop loan. For instance, in Texas, the pawnshop should not exceed a maximum APR of 240%.
Despite the hefty APRs being charged on a loan, pawnshop loans have another major disadvantage.
The item pawned by you will be returned to you if you repay the loan. Failing to repay, your item gets owned by the pawnshop and they can resell it.
Imagine losing something precious that has been gifted by someone dearest to you. Extremely painful, right?
It also hurts when you lose something which you liked a lot and worked hard to buy it.
There are some pawnshops, that allow you to extend the repayment period. However, such extensions come with higher interest rates, fees and other relevant charges.
Having said that, personal loans are always a great alternative to pawnshop loans.
Effective tips for repayment
— Just avoid them. You don’t want to lose your valuable items in an event of failing to repay.
— Opt for alternatives like a credit card or a personal loan, which in most cases, offer the same amounts.
— If you have already taken a loan, create a budget and cut short on a few expenses.
This will allow you to gather the funds necessary to release the pawned item faster.
Once again, pawnshop loans are something to be avoided at all costs.
Cash Advance Apps
Cash advance apps work similarly to payday loans, where people can borrow against their paychecks.
Because of the easy access, they are also popular among most borrowers. These are only available for people receiving regular income and dues get deducted automatically.
On average, cash advance apps are available at APRs of up to 30%.
These apps come with a monthly fee or a fee based on usage. It is, however, a good option during emergency requirements for funds.
But making it into a habit (every month) will often lead to financial difficulties.
People always tend towards such cash advance apps instead of creating a good budget. Because it’s easy.
This will lead to habitual unhealthy financial habits, which would increase the problems.
The amount you earn will be deducted for the repayment, which will make you fall short of your income. This would encourage users to utilize these apps, again and again, leading to a debt cycle.
Effective tips for repayment
— Like with any other loans mentioned in this list, having a budget will avoid the necessity of a loan.
— Before you get a loan from a cash advance app, do some groundwork. Reading about user reviews is one of the best ways that a person can know about the lender.
— Avoid cash advance apps unless it is an extreme emergency.
Credit Card Advances
A short-term loan offered by a credit card lender is called a Credit Card Advance and higher APR than a credit card.
Like cash advance apps, credit card advances are easily accessible making them convenient.
There is no approval process and all you need is a credit card. Credit card advances do not have income requirements or credit history requirements. It’s based on the credit limit.
How would a credit card advance affect you financially? Well, the interest rate for credit cards in the US is around 14.5% on average in 2022.
The interest rates for credit card advances are higher than the usual interest rates.
On average, most people have three to four credit cards. Imagine what happens when a person decides to take credit card advances on all the cards available.
Adding to that, every time you take a credit card advance, you will also be subject to other fees.
It would also affect your credit scores and increases your credit utilization. Credit utilization sums up to 30% of the entire credit score.
Effective tips for repayment
— Only borrow the amount you need if you still want to go for a credit card advance. Keep in mind that the more amount you borrow, the higher will be the interest rate.
— Credit card advances start incurring interest as soon as you take out a loan. Therefore, try to pay off early to avoid paying more in terms of interest.
— Always shop around for the best deals available because some credit card issuers offer lower rates.
Credit card advances may not be as harmful as pawnshop loans or payday loans. Yet, they would still affect your financial situation negatively, so, it is better to avoid them.
Secured Loans for Debt Consolidation
Secured loans come with great benefits such as low APRs or low eligibility requirements.
Generally, secured loans are backed by collateral such as home equity or automobiles.
But here, we are talking about the specific purpose for which you are getting a secured loan. Yes, debt consolidation.
Debt consolidation is clearing off all the existing debt and consolidating it into a single debt.
It is often advantageous as you won’t have to be attentive to various loans you have or their interest rates.
This means you are typically opting for a huge loan instead of several small and medium loans.
This is a good idea and certainly a commendable financial measure against debt.
But remember that you are keeping collateral for getting this loan. For such huge amounts, the only suitable collateral would be your home equity.
Most debt consolidation purposes include paying off your existing loans and credit card debt.
This makes you free from your debt, but to what extent? You should consider the fact that you will again be eligible for getting those loans.
Unless creating a proper budget, people choose to take such loans again when necessary.
This would again make you subject to debt while still having to pay the existing debt consolidation loan.
In the unlikely event of failing to repay your secured debt consolidation loan, you will lose your collateral.
Effective tips for repayment
— When you get a secured debt consolidation loan, only borrow the amount necessary.
— Create a proper budget that includes the repayment as well as your expenses.
— The major tip is to avoid taking further loans as it defeats the purpose of getting a debt consolidation loan.
Unless you borrow money again through loans or credit cards, debt consolidation loans are advantageous.
Through proper financial planning and budgeting, you can always try to avoid getting a loan.
Auto Title Loans
Title loans are another type of secured loan offered based on an auto title. This generally means that you get a loan which is backed by the title of your automobile.
Such loans usually have a high APR and often have short-term repayment periods.
The individual would have to say goodbye to his/her car in an unfortunate situation of failing to repay. That too, at a price that is far lesser than what they’ve paid for buying the car.
The average APR for an auto title loan can be as high as 300% in the US. Thousands of cars are said to be repossessed as a result of people failing to repay auto title loans.
Personal loans can be a great alternative for those seeking a short-term solution for a loan.
There are certain loans such as secured personal loans and unsecured personal loans, which are beneficial.
Especially deemed advantageous compared to the loans mentioned in this list.
Apart from the secured loan for debt consolidation, most loans in this list have very high APRs.
Even if they have reasonable interest rates, some may lead to unhealthy financial habits.
It is important for everyone to know the importance of budgeting and having an emergency cash reserve.
By doing so, one can avoid the requirement of a loan with the funds they have.
Even if someone does get any of the loans described in this article, it can be paid off with proper budgeting.
What I suggest is that you maintain a good credit score, a nest egg for emergencies, and good financial habits.
By having a good credit score, you can always get a personal loan at favourable terms. Specifically compared to the loans with excessive APRs as discussed here.
If you have a bad credit score, you can still get a secured loan with a reasonable APR.
The secured loans would also be helpful for you to enhance your existing credit score.
By making it a habit to save and invest, you will always have a good financial situation.
You don’t even need to have a lot of experience or knowledge to start healthy financial habits.
You can even start by saving low or creating a basic budget plan that’ll allow you to become financially literate.
If you earn a good income, set some money aside for savings and investments.
Through savings, you can always meet your financial needs, particularly during money-related emergencies.
With investing money, you can even avoid the necessity of getting a loan. How? The returns you make on your investments are enough to take care of various financial needs.
Not everyone has robust investment strategies for effectively making returns on their capital.
At the same time, not everyone is knowledgeable enough to handle their investment needs.
In such circumstances, it is wise to leave such aspects to professionals like me.
Are you looking for someone to handle your investment needs effectively?
Do you seek the assistance of a professional financial adviser or wealth manager?
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Don’t hesitate to contact me to get access to the best-in-class financial services I offer.
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Adam is an internationally recognised author on financial matters, with over 544.4 million answers views on Quora.com and a widely sold book on Amazon and a contributor on Forbes.