What are the dangers of unsecured personal loans?
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UPDATED: Jul 10, 2012
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The dangers of unsecured personal loans are present for both lenders and borrowers alike. Banks usually aren’t very interested in giving unsecured financing because unsecured loans don’t require collateral, which places banks at greater risk of not reclaiming all of their money. Borrowers with very good credit may be able to obtain these types of financing from banks, but most will have to settle with borrowing from a different lending source, like peer-to-peer lenders.
Since unsecured loans are not “insured” by any property or assets, they usually carry a high interest rate. In contrast to this, if borrowers put up their houses or vehicles as collateral for money, then their financing would be considered secure since it is “secured” by their collateral.
Collateral and “security” can make it relatively easy for a borrower to get financing since it’s safer for lenders.
However, secured loans prove dangerous for borrowers since they risk losing their collateral. That’s not to say unsecured options are completely safe, though.
The high interest rates associated with unsecured personal loans can prove to be very dangerous. Borrowers with high interest rates will likely make larger monthly payments.
For example, if a borrower has a $5,000 unsecured personal loan that has a term of 24 months with a 30 percent yearly interest rate, the first monthly payment would be $280.
Since most unsecured personal loan borrowers don’t have a huge amount of cash—hence why they needed to borrow money in the first place—they will most likely only make the minimum agreed-upon monthly payment. By paying the minimum installment, borrowers subject themselves to the full amount of what’s often a very higher rate of interest.
Returning to our example above, if our borrower pays the minimum monthly payment for the entire duration of his unsecured loan’s term, he will pay $1,710 in interest. But, if he were to allot additional money to that payment each month, he would cut that total interest down significantly.
However, making larger monthly payments isn’t always an option. Unsecured personal loans often come with prepayment penalties that do not give borrowers the option to make larger payments. This prevents borrowers from making payments sizable enough to curb the high interest on their financing, thus ensuring that lenders receive the agreed-upon interest on their money.
Borrowers who don’t pay their minimum could face fee penalties, credit damage, and even a rise in their agreed-upon interest rate.