Personal Loan Mistakes to Avoid: A Guide to Smarter Borrowing

Applying for Too Many Loans at Once

It’s natural to shop around when you need a personal loan, but every application you formally submit can trigger a hard inquiry on your credit report. Multiple hard inquiries in a short span can lower your credit score, which in turn can affect the rates you’re offered or whether you’re approved at all.

While some credit scoring models may group multiple loan applications made within a short period as a single inquiry for rate-shopping purposes, the safest approach is to use prequalification tools that perform a soft inquiry, which doesn’t affect your score. This allows you to compare potential rates without the negative impact of multiple hard pulls.

Use prequalification or preapproval tools that don’t require a hard credit check.
Limit formal applications to the few lenders you’re seriously considering.
Compare each offer by its APR and total cost, not just the monthly payment.

Sources: Experian, Yahoo Finance (GOBankingRates)

7 Personal Loan Mistakes That Could Cost You Thousands

Ignoring the Full APR vs. Interest Rate

The interest rate is what you pay on the principal amount, but it doesn’t include fees that the lender may charge. The Annual Percentage Rate (APR) is a more comprehensive measure of the loan’s true cost because it includes interest and certain fees, such as an origination fee. Comparing loans by their APRs is generally a more accurate way to identify the most affordable option.

A loan with a lower interest rate but higher fees may end up costing you more in the long run than a loan with a slightly higher rate and no origination fee. Always ask lenders for a written disclosure of the APR and any fees so you can make an apples-to-apples comparison.

Use the APR, not just the advertised interest rate, when comparing loans.
Ask for a loan estimate or similar document that clearly lists the APR and itemized fees.
Remember that the APR reflects the total cost of credit, helping you avoid surprises.

Sources: Consumer Financial Protection Bureau, Experian, Yahoo Finance (GOBankingRates)

Overlooking Origination Fees

An origination fee is a charge some lenders apply for processing a new loan. It’s commonly a percentage of the loan amount and is often deducted from the loan proceeds before you receive the funds.

Because origination fees can add significantly to your borrowing costs, it’s important to factor them into your comparison. If you’re considering two loans with similar interest rates, the one with the lower (or zero) origination fee is likely to be more cost-effective overall.

Always ask whether a lender charges an origination fee and what it amounts to.
Calculate how the fee affects the amount you receive and your effective cost.
Be wary of lenders that advertise very low rates but charge high origination fees.

Sources: Achieve

Borrowing More Than You Can Afford

Personal loans can seem appealing because they offer a lump sum that might be larger than what you initially needed. But taking out more than you can comfortably repay can lead to financial strain. If a payment is missed, you may face late fees, and if the delinquency continues, it could be reported to credit bureaus, harming your credit score.

Before applying, carefully evaluate your monthly budget. Determine how much of your income can go toward a loan payment without compromising your essential expenses. The right loan amount is one that meets your needs while leaving you with enough flexibility for unexpected costs.

Calculate your disposable income and existing debt obligations.
Borrow only what you need, even if you qualify for more.
Leave room in your budget for emergencies and other saving goals.

Sources: Experian

Not Reading the Fine Print

Loan agreements are legally binding contracts, and they often contain terms that can affect your total cost. For instance, some loans include a prepayment penalty, meaning you may be charged a fee if you pay off the loan early. Others might impose late fees for missed payments. Overlooking these details can lead to unexpected expenses.

The Truth in Lending Act (TILA) requires lenders to disclose key loan terms, including the APR, finance charge, payment schedule, and any prepayment penalties. However, it’s your responsibility to read and understand these disclosures before signing. If something is unclear, don’t hesitate to ask the lender for clarification.

Review the loan contract for any fees, especially prepayment penalties and late fees.
Make sure you understand the total finance charge and the APR.
If you have questions, contact the lender before you sign.

Sources: Consumer Financial Protection Bureau, Experian

Falling for Upfront-Fee Loan Scams

Scammers often lure borrowers with too-good-to-be-true loan offers and then demand an upfront fee for 'processing,' 'insurance,' or 'paperwork.' Legitimate lenders generally do not ask you to pay a fee before disbursing the loan; instead, they may deduct any origination fee from the loan proceeds.

Be wary of lenders who guarantee approval regardless of your credit history, pressure you to act quickly, or ask for payment via gift card or wire transfer. Also, be cautious with unsolicited loan offers, such as 'live check' mailings, which could be scams if they don’t include proper disclosures. Always verify the lender’s reputation and read the fine print.

Avoid any lender that insists on a fee before you receive the loan funds.
Double-check the lender’s physical address, website, and contact information.
If an offer arrives by mail, email, or text and seems suspicious, do not provide personal information and do not cash any check enclosed.

Sources: Consumer Financial Protection Bureau

Using Payday Loans as an Alternative

When you need cash quickly, payday loans may appear convenient, but they often come with very high costs. Payday loans are short-term, typically due on your next payday, and they can carry annual percentage rates (APRs) that are significantly higher than those of most personal loans. Because the entire balance is due so soon, borrowers who can’t repay in time might find themselves in a cycle of taking out new loans to cover the first, incurring additional fees.

Some lenders do not report payday loan payments to the major credit bureaus, so making on-time payments may not help you build positive credit history. However, if you default, the lender could report that to the bureaus, harming your credit. Weigh these risks carefully and explore other options, such as credit union loans, credit counseling, or negotiating a payment plan with your creditors.

Read the loan terms carefully and note the APR, which is often in the triple digits.
Be sure you can repay the full balance by the due date to avoid additional fees.
Consider personal loan alternatives, such as credit union loans or hardship programs, before choosing a payday loan.

Sources: Upgrade

Frequently asked questions

What are the most common personal loan scams?

Common scams include lenders that demand an upfront fee before funding your loan, guarantees of approval without a credit check, and unsolicited offers like 'live check' mailings that lack required disclosures. Legitimate lenders typically do not charge an upfront fee; they may deduct any origination fee from the loan proceeds. Always verify a lender’s credentials and read the loan agreement carefully.

Sources: Consumer Financial Protection Bureau

How can I avoid paying unnecessary fees?

Start by comparing personal loan offers using the APR, which includes many common fees like origination charges. Ask lenders to explain all fees, including late fees and prepayment penalties. The Truth in Lending Act requires lenders to disclose these costs before you sign. Avoid loans with high origination fees or any requirement to pay an upfront fee before disbursement, which could be a sign of a scam.

Sources: Consumer Financial Protection Bureau, Experian, Achieve

Is it bad to apply to multiple lenders?

Applying to multiple lenders can result in multiple hard inquiries on your credit report, which can lower your credit score. Some credit scoring models may group loan applications made within a short period as a single inquiry for rate shopping, but this isn’t guaranteed. To minimize impact, use prequalification tools that rely on a soft credit check and only submit formal applications to lenders you’re seriously considering.

Sources: Yahoo Finance (GOBankingRates)

What should I check before signing a loan agreement?

Review the Truth in Lending Act disclosure to verify the APR, finance charges, payment schedule, and any prepayment penalties. Check whether an origination fee is deducted from the loan amount and how it affects the total cost. Make sure the monthly payment fits your budget and that you understand all terms. If any condition is unclear, ask the lender for clarification before signing.