The 3 Biggest Risks of Taking Out a Personal Loan

Personal loans can be a good way to borrow money when you need to. After all, these loans have set payment schedules, so there are no surprises -- and the interest rates you'll pay are often well below what you'd be charged if you used a credit card

But while there are benefits to using a personal loan to access funds you need, there are also some major risks you could face when you take out this type of loan. Here are three big ones you need to be aware of. 

A woman on a phone call with her hand on her forehead seemingly getting bad news.

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1. Not being able to make your payment

The single biggest risk to taking out a personal loan is not being able to afford to keep your commitment to your lender. If your monthly loan payment is too high for you to make and you default on your loan, you could find yourself dealing with serious financial consequences. 

In addition to damage to your credit score, you could also face legal action. This could lead to a court judgement against you that potentially could be enforced by garnishment of your wages or a lien being put onto any property you own. 

To make sure this doesn't happen, find out exactly how much your personal loan payments will be and see how they will fit into your budget. If you find you can't easily afford the payments, don't borrow.

Many people also default on loans because of a job loss or medical issue. To guard against this risk, aim to save up an emergency fund with several months of living expenses before you borrow. That way, if you lose your job or can't work because you get sick, you'll still have money to pay your loan. 

2. Getting too deeply into debt

If you take on a personal loan and commit to making monthly payments, this debt could interfere with your ability to accomplish other goals you may have. That's because your income will now have to go toward paying your loan off instead of doing other things with your money, such as saving for retirement.

You want to avoid tying up your future income by taking on a lot of debt or by taking on any unnecessary debt at all. So before you take out a loan, consider whether you really need to borrow and whether getting into this debt is worth the sacrifice your future self will have to make as you pay it off. 

The risk of getting too deeply into debt is even bigger if you are taking out a personal loan to consolidate debt and using the loan proceeds to repay your credit cards. If you pay off your cards and free up your credit limit, you could end up charging on the cards again if you are spending beyond your means. This could leave you with both the personal loan payment to make and a bunch of new credit card debt you have to repay. 

To avoid this, make absolutely sure you're skilled at living on a budget and not overspending before you consolidate credit card debt using a personal loan. 

3. Hurting your ability to borrow in the future

Lenders will not give you a loan if they feel that you have too much outstanding debt relative to your income. If you take out a personal loan, the payment on it will be factored in when your debt-to-income ratio is determined.

This could become a big problem if you borrow now and need to take a loan for something else later before your current loan is paid off. Say you take out a loan for your wedding. If that loan is too large relative to your income, your debt-to-income ratio could be too high for you to qualify for a home loan with your new spouse next year.

To avoid this risk, don't borrow for anything unless you absolutely need to. And if you do borrow, always keep your loan balance as low as possible and try to ensure the total outstanding amount of debt you owe -- including loans and credit card payments -- stays reasonable relative to your income. 

Minimizing these personal loan risks is worth the effort

Any time you're thinking of borrowing money, you need to know the risks going in. By understanding these three big potential risks of taking out a personal loan, you can hopefully take steps to minimize them so your decision to borrow doesn't have an adverse impact on your future.

Our Picks of the Best Personal Loans for 2020

We've vetted the market to bring you our shortlist of the best personal loan providers. Whether you're looking to pay off debt faster by slashing your interest rate or needing some extra money to tackle a big purchase, these best-in-class picks can help you reach your financial goals. Click here to get the full rundown on our top picks.

The Motley Fool owns and recommends MasterCard and Visa, and recommends American Express. We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.

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