When is a Personal Loan a Bad Idea

There are two types of personal loans that come to mind when discussing the issue of when a personal loan is a bad idea. The first, and by far the worst, is a payday loan. The second is a secured loan from the bank. Payday loans are a legal business, but because many people do not realize how the business works, many are not aware of how outrageous the interest payments are on the loan. Secured bank loans, on the other hand, usually have a very competitive interest rate. However, because you have to pledge something as collateral for the loan, you be putting more at risk than you need to.

The problem with payday loans is if you break down the difference between the amount loaned and the amount paid by the borrower, the result is the equivalent to an astronomical interest rate charged by the lending center. For example, let us say that you want to borrow $500 from one of these payday advance loan centers. In exchange for you borrowing $500, the payday advance loan center tells you that you have to give them $550 from your next paycheck. Most people get paid every two weeks. Therefore, the payday advance loan center is effectively making $50 worth of interest on $500 in only two weeks or fourteen days. Using the standard interest formula of principal multiplied by the interest rate multiplied by the time equals the interest obtained (P x R x T = I), we can calculate the interest rate charged by these businesses. If you fill in all the numbers you know (the principal (P), the time (T), and the interest (I) are known) you can solve the formula for the interest rate. In order to save you some time, I will tell you the answer. If the payday advance loan center made $50 on a $500 loan in only two weeks, that is the equivalent of charging the borrower about 261% interest. That is not a typo. The interest rate is two hundred and sixty-one percent!

Secured loans, on the other hand, will not cost you 261% and in fact, will be competitive from wherever you borrow the money. Therefore, depending on the amount you wish to borrow, your credit score, the purpose for the loan, and the timeframe for repayment, you could be looking at anywhere between about 5% to about 20%, give or take a percent or two, for an interest rate. This is obviously better than the 261% interest rate you would have to pay at a payday loan center. However, personal bank loans are usually taken for a longer time than the two weeks given in the payday loan example, and you may have to secure the bank loan. Securing the loan means that you will have to put up some kind of collateral (collateral is something that has an objective value that is equal to or greater than the amount of the loan) in order to obtain the loan. For example, if you own your car free and clear and want to borrow $2,000 from the bank for one year, you may have to pledge your car as collateral for the loan. As such, should you default on the loan, the bank can repossess your car, sell it, use the money to pay back the loan, and reimburse you the difference, if any.

As you can see, both types of loans offer disadvantages, but only the bank loan, in my opinion, offers you any advantages. I would avoid payday loans at all costs and use secured, personal bank loans only if absolutely necessary. Truthfully, if you have a credit card that has a low interest rate (and no, 10% or more is not low), you may want to consider using it and paying off the balance as soon as possible. You may have to pay a little more interest than with the bank loan, but you do not need to get approved for the money and you do not have to put up any collateral.

Ultimately, the choice is up to you. Carefully assess your situation and see if there is any way in which you can “make it” without borrowing money.