Risky loans — deals that can ruin financial lives — didn’t disappear with the recession. Ruinous vehicle loans, home loans, payday loans and loan scams live on. The economic crash, fueled by risky lending, should have convinced us to be careful. But memories are short. So, here are six red flags that should signal you to back away and four tips for safer borrowing.
First, though, a basic principle: Anyone considering a loan — whether a home loan, auto loan or personal loan of any sort — should vet it carefully, says Sam Gilford, a spokesman for the federal Consumer Financial Protection Bureau.
“Consumers should make sure to thoroughly review the terms of any loan before signing on the dotted line, consider alternative options and ask questions about anything they don’t understand,” he said in an email.
Here are six signs of a risky deal:
Red flag 1: ‘No credit? No problem.’
Ads promising “No credit? No problem,” “We never say ‘No'” and the like sure are tempting when you are short of money and are digging your way out of the credit score basement.
But think about it: Legitimate lenders take a chance lending money. To ensure you’ll repay it, they dig into your credit background, asking you to fill out an application listing your assets, debts, expenses and sources of income and verifying each of your claims. They’ll also get your permission to pull your credit score.
When a lender isn’t interested in all that, you’re looking at trouble — possibly, a scam.
Red flag 2: Interest-only periods
A loan starting with a period of months or years when you pay only interest may sound like a sweet deal because the payments during this period are smaller.
The problem is, after all the payments you made in the interest-only period, you’ll still have the entire loan to pay off. You’re no closer to owning your car or house than before and you’re still on the hook for the loan.
Red flag 3: Adjustable rates
Adjustable-rate mortgages (ARMs) were a dirty word when ARMs with risky features led millions of homeowners to default in the lead-up to the Great Recession. Homeowners took on ARMs assuming they could refinance or sell when their interest rates rose. But millions got stuck when they couldn’t refinance because they’d lost jobs or their home’s value dropped to less than the value of the mortgages. The United States saw nearly 6 million home foreclosures between 2007 and 2015, according to RealtyTrac.
There are good uses for adjustable-rate mortgages. Sophisticated borrowers may, for example, use them for the short-term when they have better uses for their own money. But that’s risky unless you have ready cash to pay off your ARM the minute the rate starts going up.
Red flag 4: Super-long loans
Borrowing is all about affordability. Reducing your monthly payments could get you into a better home, allow you to buy that new car or truck you’ve got your eye on or just let you breathe more easily each month. So it’s understandable that a 40-year mortgage or a seven-year vehicle loan would seem attractive.
Longer loans lower your payments a bit by stretching them over more years. But you pay through the nose for the privilege, and the payments aren’t that much smaller. Get the lender to break down and compare costs so you can see how much more you’d pay for a longer loan. A super-long loan is better than an interest-only loan, but not by much since most of your monthly payment goes to interest instead of equity — your ownership share of the property.
Red flag 5: Advance fees
Just hang up if you get a phone call offering you a loan (or “grant”). It’s illegal for U.S. companies to promise credit cards or loans over the phone and require payment in advance. Calls like this are probably not lenders anyway. It could be a scammer trying to convince you to send upfront “fees” or “down payments.” You, then, have to wait for the loan to arrive. And wait, and wait ….
Rule of thumb: Pay no fees until you have the loan money in your hands.
Red flag 6: Payday loans
Payday loans are expensive short-term loans with certain risky features. Typically, you give the lender a post-dated check for the amount you’re borrowing plus fees, to be taken from your next paycheck. Failure to repay on time sets off more fees and interest charges that drag some borrowers deep into debt.
Red-flag features include:
- Astronomical interest rates: On average, short-term payday loans charge 391 percent APR (annual percentage rate), according to the Center for Responsible Lending (CRL). For comparison, Money Talks News’ credit-card center shows credit-card rates ranging around 10 percent to 20 percent. APRs on personal loans can be cheaper.
- Fees that pile up: Payday lenders cater to people in financial trouble. If you fall behind or your check bounces, you can rack up fees, which lead to a debt bigger than your original loan.
- Repeat borrowing: Borrowers who can’t pay off a loan by the end of its term often get new loans, leading to a cycle of debt that buries them. “Payday loan stores reap billions of dollars in interest and fees on a product designed to force borrowers into repeat loans,” the CRL says.
- Collection practices: Payday lenders vary, but the worst have a reputation for harassment and relentless collection practices.
Some states ban or regulate payday loans. However, 32 states “permit payday lenders and permit loans based on checks written on consumers’ bank accounts at triple-digit interest rates, or with no rate cap at all,” according to the Consumer Federation of America. Find your state’s status on this CFA map.
4 safety tips
- Mortgages: Stick with federally “Qualified Mortgages” that have safeguards built in. If you can’t get one yet, double down on improving your eligibility rather than accepting a risky, higher-cost mortgage. The Consumer Financial Protection Bureau compares pros, cons and features of various mortgage types.
- Vehicle loans: Get the best deal on a vehicle loan by ignoring the sales talk and avoiding longer loans. Get a four-year or five-year loan, and focus on the APR.
- Emergency borrowing: It’s better to borrow from friends or family or even a credit card if you must. If you use a payday lender, read the CFPB’s guidance. Payday lenders vary, so shop for the best deal — don’t choose based on convenience.
- Plan ahead: Everyone gets into a pinch occasionally. Prepare by improving your credit so you’re eligible for a small personal loan with a safer fixed interest rate. Find a credit union that charges less than a bank and join now as insurance. Build an emergency savings account (hands off except for true emergencies) and fatten it by earning extra money.
Have you encountered these or other red flags when shopping for loans? Share with us in comments below or on our Facebook page.