There are many reasons a person might consider taking out a personal loan. Sometimes a personal loan is a necessity; for example, if you wreck your car and must purchase a new one. Other times personal loans are obtained for "frivolous" expenses like a boat or RV. Whatever your reason for considering taking out a personal loan, there are several risks you should consider before taking on the debt; such as simply paying too much to compromising your financial independence. It is sensible to think not only tactically - to ensure you obtain the best terms available - but also strategically - to ensure that the loan in question is a sensible use of your hard-earned borrowing privileges.
Some Risks to Consider with Personal Loans Are:
1. Lowering Your Credit Score
A requirement of getting a personal loan is having your credit score run, which can translate to your credit score taking a hit. A decline in your personal credit score may impact your future access to credit, especially when you may need it the most.
2. Repercussions of Pledging Assets
Risks from pledging assets to secure the loan. A personal loan secured by stocks and/or bonds, i.e., a margin loan, could result in your lender liquidating some or all of your securities portfolio at the worst possible time if you are unable to either increase the amount of collateral securing the loan or if you can’t pay down the loan during a major market decline (a margin call).
3. Investment That Don't Pan Out
Underestimating the risks of loss from an investment made with borrowed funds: Leveraged investments magnify profits and losses. Therefore, committing leveraged capital must follow objective analysis that shows there is a higher degree of certainty of positive return than with an unleveraged investment. The one certainty is that the money borrowed will have to be repaid – no matter the profitability of the investment.
4. Negotiating Terms
There are several terms to a personal loan, almost all of which are negotiable. Make sure you don't agree to sub-optimal terms on the following items:
- Interest rate, and how it’s calculated
- Advance rate, i.e. the amount borrowed relative to the value of the collateral (also referred to as loan-to-value, or LTV)
- Personal guarantees
- Co-signer requirements
- Up-front fees
- Pre-payment fees
- Rescission terms (see below), etc.
First, prioritize the loan terms most important to your situation, e.g., is longer maturity more important than the lowest rate? Then, shop around for the deal that provides the best set of terms for you.
It is advisable to develop relationships with at least a few potential lenders: conventional and within the so-called ‘FinTech‘ community of on-line lenders. If you have good credit, many lenders will want your business, as they are hungry now to make good loans.
5. Acting Rashly
According to Bankrate, Inc., “A little-known power called the "right of rescission" gives borrowers the ability, in certain circumstances, to cancel their loan deals within three days, no questions asked, and walk away.”1 Allow yourself this time to fully consider the pros and cons of taking out a personal loan and don’t be shy about cancelling if you have a change of heart. Do what’s best for you!
6. Reduced Financial Flexibility
Taking out a personal loan is a major commitment that can compromise your ability to meet other obligations that you have, perhaps even your ability to make ends meet. A personal loan, if not paid back per its terms, can become a financial nightmare:the lender can charge double-digit default interest and fees, including the cost of collection and legal fees all of which could result in you owing multiples of the original principal amount.
We recommend you build a spreadsheet to compare all the costs and benefits of the personal loan vs. the use of the funds. We also suggest you make a checklist of as many qualitative factors involved in the decision to borrow as you can think of.
With this disciplined process you will have more comfort in the decision to take on the financial commitments of a personal loan, or you may even decide it's either not worth it or it's better to wait for a superior opportunity.
About the Author
Marc Katz is a former managing director of Lehman Brothers’ and Bank of America’s debt capital markets risk solutions groups. He has extensive daily experience in the management of complex financing arrangements as well as fixed income trading. Marc also has an inside knowledge of the debt transactions for some of America’s leading companies; including taxable and tax exempt investment, leasing, private placements and hybrid securities.