Any time you take out a loan, you’re taking a risk with someone else’s money. Borrow wisely instead, and a loan can be a great tool that builds credit and keeps you on the good side of debt. But no matter the type of debt you have, take on more than you can afford to pay back, and you may be setting yourself up for a financial failure that’s hard to recover from.
Some loans may look appealing on the surface—an easy way to get some cash flow if money is tight, or if you need it for an emergency and can’t find financing elsewhere. But look more closely, and the exorbitant fees, sky-high interest rates and sketchy terms could leave you owing far more than you meant to borrow..
Here are a few examples of high-risk loans to avoid at all costs:
It seemed like a good idea at the time to let that nickel-and-dime pawnshop down the street hold onto your flat-screen TV as collateral for a cash loan you needed fast. There was no credit check required, and you trusted that your stuff would be in good hands until you paid off the money.
The problem is that most pawnshop loans come with crazy interest rates (the monthly average of 10 percent works out to 12% APR), with some establishments charging storage fees to hold your items until you pay back what you’ve borrowed, ultimately driving up the total cost of the loan more than it’s worth. If you can’t or won’t repay the loan, you forfeit your property to the pawnshop, and your TV (or other valuables you’ve handed over) ends up in someone else’s possession.
Payday loans are considered one of the most predatory in the business since they exploit lower income workers who have a hard time making ends meet with oppressive interest rates that send them further into financial trouble.
These loans are usually treated as a small cash advance that you’re expected to repay out of your next paycheck. But with annual interest rates upwards of 400 percent, that could mean most, if not all, of your next paycheck going straight to your lender, forcing you to continue borrowing more money and entering a cycle of debt you can’t escape.
Legislators across the country have taken steps to clamp down on unfair payday loan practices, so be wary of payday lenders who pretend to be another kind of lender, or who change their terms just to get around the law.
Car title loans
How does a loan sound where you’d put up as collateral your car—which you’ve already paid off with an auto loan—at 250 to 300 percent annual interest? Default on the loan, lose your car.
We wouldn’t recommend a car title loan as a viable lending option under any circumstances. To put an asset as expensive as a vehicle in the hands of a lender gives them the authority to take it from you if you don’t pay off the loan -- and APRs will be inflated to astronomical proportions just to make it harder for you to follow through. That’s why car title loans are similar to pawnshop loans; risking loss of a valuable asset isn’t worth the money loaned to you. Keep your car title. If your finances are spread too thin, you’d be better off selling your car instead of potentially gambling it away into the hands of an unscrupulous lender.
Tax refund anticipation loans
By now, you’ve received your income tax refund, but you might be thinking about how you’d like to get next year’s earlier than usual if you’re really, really impatient for yours. For that, you can take a tax refund anticipation loan, or RAL, to get your money early.
After calculating how much money you’re due to receive from the IRS, you’d work with a lender (usually through a tax preparer) for a loan in the full or partial amount of your anticipated refund. You’d receive the money within a couple of days, and when your real refund comes through, it’s used to cancel out the loan.
What many people don’t realize is that with fees and interest rates up to 36 percent attached to RALs, the total cost of the loan can climb so high that your tax refund may not be enough to cover it. If your refund is smaller than your loan amount, you’ll be responsible for paying the difference. That expense, sadly, won’t be tax deductible on your next return.
Good things come to those who wait, so if you’re eagerly anticipating your tax refund, remember that patience is a virtue ... but Refund Anticipation Loans are not.
Contributing to a 401(k) is one way to shore up your retirement savings if your employer has one in place. You can’t withdraw from your 401(k) before age 59 ½ without paying a penalty, but you can borrow from your plan if you want early access to your funds.
Is taking a loan on your 401(k) a risky move? It can be, for the very simple reason that you’re borrowing against your portfolio instead o saving towards it. This can stall your investment momentum and reduce the amount of contributions you’d end up with at retirement if you left your account intact.
A 401(k) loan will also get you double taxed. When you take out the loan, you’re borrowing from your principal and your interest -- interest you’ll need to repay back into your account with income you’ve earned and been taxed on. Then, you’ll get taxed again when you go to withdraw your funds at retirement. When you start canceling out your tax advantages, why have a 401(k) in the first place?
Credit card cash advances
A cash advance on your credit limit might not sound so bad when you consider that it’s extra money you were going to pay back on your monthly balance anyway. Your card provider may even encourage it by sending you blank personal "convenience" checks that resemble something from your checking account, but are actually an extension of your credit line. Plus, there’s no preapprovals needed or hard checks to your credit report.
This might be OK once in awhile if you’re hard up for a few dollars in a pinch. But since it’s treated like a cash advance, you’ll get hit with interest rates of about 20 percent or more on top of your existing credit card APR. Take extra fees into account, and it can impact your wallet if you’re prone to carrying a balance from month to month.
When are risky loans worth the risk?
Lenders of high-risk loans stay in business knowing that borrowers will act on desperation and pay inflated fees and interest rates, even if it costs them more money in the long run.
Should you take advantage of one of the above loans? If you’re in an absolute bind or unexpected circumstance without a financial cushion to back you up, use them as a last resort. Ultimately, by keeping your finances in shape, you’ll have less need for last-minute borrowing. Here are some tips to keep in mind:
Stay conservative with the amount you borrow**. If you do take out a loan, keeping your loan principal low gives higher APRs and fees less chance to overextend your finances, minimizing the risk you take with a risky loan.
Build an emergency savings**. Whether it’s through contributing to a high-APY account or investment plan, high-risk loans can be avoided by improving your financial foundation.
Increase your income**. Alleviate the need to take out unnecessary loans and free up your finances by better budgeting, cutting back on expenses, finding a second stream of revenue, and looking for ways to reduce debt.