Why You Should Avoid High-Interest Rate Loans

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Category: Loans
Posted on: 02/26/2020
Why You Should Avoid High-Interest Rate Loans

When an emergency expense comes up, or you need extra cash to get through a difficult period, loans provide a temporary solution. Depending on the terms you're offered, obtaining financing from a lender can be a good idea. Millions of Americans use loans to pay for college, buy homes/cars and start businesses.

However, if you’re unable to find a lender that offers you customer-friendly interest rates, taking out a loan may not be a smart decision. This is because some loans come with rates so high that consumers end up paying a lot in interest charges, sometimes even more than the original loan amount. You must avoid loans like these.

How would you know if the interest rate you’re being offered is too high? Find out below:

What’s a Customer-Friendly Interest Rate?

According to a 2019 study by Experian, one of the three major credit monitoring bureaus, the average interest rate charged on personal loans is 9.41%. It’s important to note that interest rates vary with lenders, and the borrower’s credit rating and income level play a significant role. Some borrowers will be offered rates lower than the average, and others, higher. Generally, the rates on personal loans range from 6% to 36%.

Interest rates below the national average of 9.41% can be regarded as very good. Anything slightly above the average may be considered fair and customer-friendly. When the interest rate starts to exceed 25%, however, it’s becoming too high.

For example, say a consumer takes out a 5-year loan of $10,000 at an interest rate of 25%. Over the five-year term, the consumer will pay back a total of over $17,600. Now, if the loan had come at an interest rate of 9%, the consumer would only have paid back $12,455. By securing a lower interest rate, the consumer would have saved over $5,000.

What if the loan came at an interest rate of 36%? The consumer would have paid back $21,679 over five years. The interest charges on that loan alone would have totaled $11,679, considerably higher than the original principal.

5 Disadvantages of High-Interest Rate Loans

Not everybody will be able to secure a loan with interest rates below 10%. Per the CFPB, one in five Americans has credit scores in the subprime and below category. People in this category may struggle to get loans with low-interest rates. If you’re in this category, what happens if you decide to ignore the consequences and accept a high-interest rate loan?

1. Interest Charges Add Up Quickly

The rate at which interest is charged on a loan’s principal varies from one lender to another. Lenders typically compound interest daily, monthly or quarterly. With higher interest rates, a loan’s compounding effect becomes more pronounced.

For example, if you take out a loan of $10,000 at a 30% interest rate, your balance compounds at 2.5% per month. That means after the first month, your loan would have increased by $250. On the surface, 30% may seem like a manageable interest rate, but in the first year alone, over $2,600 in interest would have accumulated on your balance.

Throughout the life of the loan, the 2.5% monthly rate remains, and you’ll end up paying back interest of over $9,400. A $10K loan that costs you over $9k isn’t a good financial decision.

2. It Becomes Difficult to Break Out of the Debt Cycle

Using the illustration above, it would require monthly payments of $323.53 over five years to pay back the $10,000 loan. For sixty months, you’d have to take out over $320 of your income without fail. If you miss one, you’d have to increase subsequent monthly payments or the duration of the loan increases. You also risk being charged a small fee as a late payment penalty. This is how many people get stuck in the debt cycle. In the end, they spend decades paying off loans because they underestimated the effect of high-interest rates.

3. Missed Payments Will Reduce Your Credit Score

Large monthly payments disrupt your finances, making it more challenging to maintain your lifestyle while paying off the loan. Before you realize it, you've started making late payments and accruing penalty fees. Once you miss more than one payment, the lender can send a negative report to the credit reporting agencies.

Consequently, your credit rating takes a hit. In some states in the US, potential employers are allowed to review your credit report, and you may lose opportunities because you defaulted on your loan payments. Furthermore, bad credit means you can’t take out a low-interest rate loan to consolidate the old one.

4. You’re at Risk of a Lawsuit

If you miss more than three consecutive payments, the lender can bring a lawsuit against you. If the judge rules in favor of the lender, your wages may be garnished and your bank accounts frozen. An alternative would be to reach out to the lender and seek deferment; this enables you to suspend payments for some months. However, you’ll still have to pay back the loan, and the high-interest rates will continue to count and compound on your balance.

5. Watch Out for Early Repayment Penalties

What if you take out a high-interest rate loan in the hope that your finances improve? If your finances improve, you may still be penalized for paying off the loan earlier than stated in the terms. Some loans charge early repayment penalties, and how much you’re charged depends on your balance and how many months of payment you have left.

Final Note

The effect of high-interest loans goes beyond the percentages. Their compounding effect, the large monthly payments, and the more extended repayment schedule have caused significant disruption to the finances of millions of people. With rates as high as 36% (some payday loans charge over 100%), you’re very likely to end up in a cycle of debt repayment for most of your life. You’re better off not accepting such a loan. An alternative would be to work on your credit and secure a better loan in the future.

What if you need financing desperately, and you’re only being offered high-interest rate loans? Ask your employer for an advance on your paycheck or borrow from close friends. You may also check out small-time banks, credit unions, and reputable online lenders. These institutions are better placed to offer you better terms, as well as work with you to make repayment easier.

Finance Guru

Finance Guru