In this article:
Loans come in many shapes and sizes. While there are laws regulating lender practices, lenders still have quite a bit of flexibility when it comes to setting their terms, fees and policies.
Before you take out a large loan that could take many years to repay, take the time to read the fine print. It's critical to understand the risks, terms and fees you'll encounter, and how you must repay the loan. Doing so can help you avoid surprises that could ruin your budget, your credit or both.
Risks Involved With a Large Loan
No matter what type of large loan you're seeking—a personal loan, mortgage or auto loan—lending contracts are complicated and filled with pages of fine print and jargon that can confuse even the most savvy borrower. While lenders should review your finances thoroughly to ensure you're not biting off more than you can chew, you could be pressured to sign a loan agreement quickly, even if it's not in your best interest.
Understanding the details of your loan agreement before you sign is critical to avoiding expensive surprises later. Some important risks to know about before you obligate yourself to a large loan include:
- Losing your car, home or other collateral: If you take out a secured loan such as a car loan or home mortgage, you could lose your property if you fail to make payments.
- Damaging your credit score: If you make late payments or miss payments altogether, your credit score will suffer. This can make it difficult to take out other loans or credit products in the future.
What to Look for in Your Loan Contract
You've applied for a loan and the lender has given you an estimate. Before you accept it, ask the following questions and carefully review the document to make sure you know the answers:
- What is the interest rate? Make sure your loan agreement spells out the exact annual percentage rate (APR) you'll pay. Find out if the loan's rate is fixed or variable, since this impacts the size of your monthly payments. While variable rates often start off lower, they can increase later, costing more money and potentially making it difficult to budget. Fixed interest rates stay the same for the life of the loan, guaranteeing consistent payment amounts. An APR calculator can help you determine how an interest rate impacts the cost of a loan. Keep in mind that the higher your credit score, the lower your interest rate is likely to be.
- What is the repayment term? Make sure to understand your repartment term, or exactly how many months or years you have to pay back the loan. The lender should provide your estimated monthly payment, and note any prepayment penalties, if they exist.
- What are the fees? Some lenders charge processing or origination fees on certain types of loans. Mortgage loans may charge many different types of fees. Do some research to find out the average fees and their amounts for the type of loan you're seeking to ensure you're not being overcharged. It's also wise to find out if the lender charges any late payment fees, prepayment penalties and any other fees that could cost you.
- Does the loan require collateral? Secured loans, such as auto and home loans, are typically guaranteed by the item the borrower is purchasing. That means if you fail to meet your obligations, the lender can take possession of the item. Other large loans, such as a large personal or business loan, may also require collateral to mitigate risk.
- Is there a balloon payment? Some loans, most commonly mortgages, might have a balloon payment due at the end of the loan term. Loans that carry balloon payments typically charge lower monthly payments but then require a large lump-sum payment later. It's likely you will know this is a feature of your loan, but make sure to know the precise details. Balloon payments are often double the average monthly loan payment and can reach into the tens of thousands of dollars. Failing to budget and plan for this type of loan can wreak havoc on your finances.
Red Flags to Avoid With Your Large Loan
Your credit score is an important factor when lenders review whether you're eligible for a traditional loan. If your credit isn't in great shape, you may be approved, but with a higher interest rate and higher fees. If your credit is poor, you might not be able to qualify for a traditional loan at all.
Consumers with poor credit who need to borrow money might instead turn to forms of borrowing with fewer requirements. When it comes to large loans, the most common of these are title loans, which use your vehicle as collateral. Unfortunately, while title loans have minimal borrowing requirements, they often have staggering fees and interest rates that can trap borrowers in vicious cycles of debt or lead to the loss of their vehicle.
Other red flags to watch out when reviewing your loan contract include:
- An APR that seems too good to be true: If all other lenders you've researched are charging higher rates, ask why yours is so much lower.
- New information in the terms and conditions: When carefully reviewing your loan documents, look out for any terms the lender hasn't already mentioned. Find out why they're included and ask for them to be removed if they don't seem necessary. If you're taking out a mortgage, which is typically the largest loan a person will get, consider having a real estate attorney review your contract.
- Prepayment penalties on personal loans: While prepayment penalties are not uncommon on conventional mortgages, many reputable personal loan lenders do not charge them. If yours does, shop around to see if you can find another option.
Improve Credit for Better Loan Options
One of the best ways to avoid dodgy loans is to build a credit history that reputable lenders will reward in their loan terms and interest rates. If your credit is less than stellar, you may struggle to access loans with favorable terms, rates and fees. To increase your ability to qualify for better loans, take steps to improve your credit score.
For those with poor credit, one way to start building credit is to get a secured credit card. Secured cards require a deposit and have low credit limits, but they offer an easy way to build positive credit history. For all other debts and bills, aim to pay every bill on time and keep your balances low. Experian Boost®ø can also help improve your FICO® Score☉ powered by Experian data by counting your utility, phone and streaming service payments toward your credit score.
Even with the best scores, though, it's important to understand the details of your loan agreement. It could make a big difference for years to come.