Sense & Centsibility Blog
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Five types of loans to avoid

Has balancing your budget become difficult? Has your credit card debt grown to the point to where payments are hard to manage? Are you experiencing a financial emergency that requires you to find a significant amount of cash right away? When looking for solutions to these challenges, it is good to examine each one closely. There are loans available that might seem like a way out of your financial stress, but they could, in fact, deliver a crippling blow to your finances. Here are five types of loans you want to avoid:

1) Payday/Cash Advance Loans

These loans can seem like a viable option to those who don’t have the credit to get a conventional loan and/or are running out of money before the end of the month. Payday loans are short-term, high-cost and are typically due by your next payday. While they are usually small, ranging from $100 to $1,000, these loans have hefty fees, averaging from $15 to $30 per every $100 you borrow. So, for example, if you need to borrow $500 and are paid bi-weekly, you will ultimately end up owing at least $575 by your next payday.

In most cases, people who take out payday loans cannot afford to pay the whole thing back by their next pay period. The loan is then rolled over or renewed, which carries more fees, which can vary from state to state.

Using the example above, let’s say the fee to rollover/renew your payday loan is $45.  Your balance has now ballooned to $620 by the end of the month; you owe an additional $120 on a $500 loan. If you don’t repay the loan on time, many payday lenders impose late fees too. In addition, if you have insufficient funds in your bank account, the bank can impose overdraft fees, thus putting you in an even deeper hole than before. 

2) Title Loans

These loans are similar to payday loans. They start small, like $100, and are meant to be paid back within 15 to 30 days. These loans allow you to borrow anywhere from 25% to 50% of the value of your vehicle in exchange for giving the lender the title to your vehicle as collateral – almost like getting a secured loan.  

Like their payday cousins, title loans are known for having high costs, which make them difficult to pay off by the due date. For example, this type of loan might charge a monthly finance fee of 25%, (which translates into an annual percentage rate of 300%), plus any additional fees. So, if you took out a title loan for $1,500, have 30 days to repay it and are charged a finance fee of 25%, you have to pay an additional $375 to borrow $1,500. This excludes any additional fees like late or rollover fees. Also, if you fall behind on a title loan, you run the risk of ultimately having your car repossessed.

3) Tax Refund Anticipation Loans

This is a loan you can take out when you anticipate a tax refund from the Internal Revenue Service (IRS). In contrast with Payday and Title loans, these loans usually do not have an interest rate. Once you get your refund, the amount you borrowed is deducted from it. While there is no interest, there are usually fees that make up for it. According to the Consumer Finance Protection Bureau, these fees typically range from $30 to $50, not taking into account any additional fees from either the tax preparer and/or your bank.

The problem with these loans is that the refund is an estimate; you really do not know how much you will get. For example, your tax preparer could make a number of miscalculations, such as including deductions that are not allowed by the IRS. If you have tax liens, unpaid alimony/child support or taxes owed from the previous year, the IRS deducts that from your refund. As a result, you are in danger of getting potentially a much smaller refund than what you planned – or potentially having so much deducted from the refund that you have no refund at all.  Therefore, if you take out a tax refund anticipation loan and the refund is lower than expected, you may find yourself unable to repay that loan.

4) Loans Against Your Retirement Plan

If you have worked at your job for a while, you might have built up your 401K/403B/457 plan for  retirement. Under hardship provisions in these plans, employees are allowed to borrow funds from what they have set aside in these accounts. Most 401K plans, for example, allow employees to borrow up to 50% of the amount they have invested, and the amount is usually capped. These loans have lower interest rates than those mentioned above, but over the life of this loan, this will ultimately end up costing you more because you are paying interest on it.

In addition, if you separate from that job, you will still be on the hook for the money you owe. You might be forced to come up with the outstanding balance in less time; most likely it will be less than the five-year period you usually have to pay it off. Finally, if you can't repay the loan right away, it will be treated as a withdrawal, meaning you will pay income tax and penalties on it the year you left the company (associated with the retirement plan/loan).

5) Peer-to-Peer (P2P) Loans

Unlike a loan from a bank or credit union, peer-to-peer loans are borrowed directly from an individual or group of investors. These loans are facilitated by a financial tech company (e.g., Sofi, Lending Club or Upstart) and do not require you to do an in-person application or even have a phone conversation with a loan officer. For personal P2P loans, the amounts can range from $2,000 up to $50,000.

The process is very similar to getting a loan at the bank. (1) Fill out an application, and get a credit check in the process. (2) You receive a letter telling you what your interest rate and payment will be, as well as your decision that you want to move forward with the loan. (3) Investors review the loan and decide if they want to fund it. (4) If/when they decide to fund it, you begin the repayment cycle.

All in all, the process of getting these loans is much faster than the other loans mentioned above, but there are major risks involved with these types of loans as well:

  1. It’s common for P2P lenders to charge origination fees; these fees could be as high as 8% of your loan amount. For example, the origination fee for a $5,000 loan could be up to $400.
  2. While interest rates on these loans can be as low as 7%, if you have a lower credit score and/or a high debt-to-income ratio, your interest rate might be as high as 36%.
  3. Peer-to-peer companies verify ID and run a credit check; however, they don't always verify a borrower's income or other debts. As a result, borrowers could be approved for a loan that is beyond their ability to pay back.
  4. If you end up falling behind or defaulting on the loans, you might not only lack the same protections as you would have with a traditional lender, but there are potentially other painful consequences. For example, these lenders are usually quick to sell off the unpaid debts to collection agencies.
  5. These loans are usually NOT eligible for debt management plans, which LSS Financial Counseling offers as a safe option to repay unsecured debt faster.

Before you consider borrowing any money, review your budget, and consider what you can afford to pay on a monthly basis.

There is no easy solution when you have a major financial challenge. When you need to come up with money quickly or are finding it difficult to pay off debt, always think about safer alternatives to the loans above. Borrow from a traditional financial institution, for example, or look for ways to increase your income (like part-time employment or a side gig).

As mentioned above, a Debt Management Plan (DMP) might be another solution for you. These plans might lower your payments, reduce interest rates by combining your debts into one monthly payment and allow you to pay off your debt in five years of less. Learn more about our DMPs and how they might be beneficial to you.

Once you have overcome a financial obstacle or if it hasn’t yet happened, try to make a point of building up savings. While it takes time, it’s worth it in the end as hopefully you can avoid or minimize the need to take out a loan if a financial emergency arises in the future.

Our trusted, nonjudgmental counselors can work with you to examine your monthly budget, assess your expenses and explore options with you. Call 888.577.2227 for a free, confidential appointment, or get your support online.

Ray McCoy


Author Ray McCoy is a Certified Financial Counselor with LSS Financial Counseling.