August 31st, 2011

3 Risky Loans and How to Avoid Them

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It happens to the best of us.

We find ourselves strapped for cash with nowhere to turn and payday is still two weeks away. When you need cash fast, some loans might seem appealing, but even in times of extreme financial desperation, there are three types of loans you should always steer clear of.

Here we’ll show you why they’re risky and how you can avoid them.

Pawn shop loans

What is it? Pawn shops offer secured loans in exchange for personal property as collateral. The pawn broker and borrower mutually agree upon a period of time, during which the borrower may purchase back the personal item, with interest. If the agreed-upon time passes, the pawned item can be sold by the pawn broker.

Why is it risky? When an individual walks into a pawn shop with an item, it’s typically because he needs money—and fast. Since the pawn broker must plan to make money off of the resale of a pawned item, items are typically sold for much less than they’re worth. Therefore, the seller ends up losing money in the value of their personal item if unable to repurchase it.

Redeeming quality: A pawn shop loan isn’t reported to credit bureaus, and it will never show up on a seller’s credit report because the private property given in exchange for the loan acts as collateral. Also, pawn shop interest rates are typically low, about 3 to 6 percent.

Payday loans

What is it? A payday loan is a small, short-term loan with notoriously high interest rates. Payday loans come from check cashers and small businesses that specialize in other financial transactions, such as money orders and transfers. Essentially, a payday loan is meant to get you from now to your next paycheck. It typically works like this: You write the lender a post-dated check or authorize an electronic funds transfer for the amount you’re borrowing, plus a fee. You walk away with the cash you need now and the lender makes a little money off of you in the form of the fee and interest.

Why is it risky? It’s not just the one-time fee that will cost you. “It’s that people can get trapped in a cycle of rolling them over,” says Megan McArdle of the Atlantic. Subsequently, the interest charges add up. Interest rates for payday loans can be in the triple digits, since they’re calculated on an annual scale. About 40% of payday borrowers have rolled over a loan five or more times in a year, according to a recent study.

Redeeming quality: There is federal oversight for this type of loan. Several states have banned payday loans all together, and usury limits have been set on payday loans to try to curb the trend of predatory lending.

Car title loans

What is it? In this type of loan, acquired from a title loan business, the borrower provides a car title as collateral. The borrower must own the car free and clear in order to apply for a loan. Another short-term loan option, a car title loan is made solely on the basis of the value and condition of the vehicle being used as collateral. In other words, the lender typically doesn’t perform a credit check of the borrower.

Why is it risky? Lenders will typically give the borrower only half of the value of the vehicle. They may offer less. And the interest rate can vary from 36% to well over 100%. At the end of the term of the loan, the borrower must at least pay the interest accrued on the loan. If the borrower cannot pay, he’ll likely lose his vehicle.

Redeeming quality: Most states require that the title loan lender hold the vehicle for 30 days to give the borrower ample time to pay the balance. Also, government regulation typically limits the number of times that a borrower can roll the loan over, keeping the borrower from staying in perpetual debt.

The Final Word

If you find yourself in need of cash quick, there are other alternatives to these risky options, including small loans from your credit union or bank or a pay advance from your employer. If you’re behind on a bill payment, contact your creditor to see if you can have an extension, finding out first what kind of fees or interest you’ll be obligated to pay. You can also check out BillFloat, which pays your bill for you so you have more time. Check out our review here.

Finally, so you don’t ever have to turn to one of these precarious? (maybe choose another word besides risky, it’s repeated a lot in the post) loans, build up your emergency fund so you’ll be prepared when faced with unexpected expenses.

Disclaimer: All information posted to this site was accurate at the time of its initial publication. Efforts have been made to keep the content up to date and accurate. However, Credit Karma does not make any guarantees about the accuracy or completeness of the information provided. For complete details of any products mentioned, visit bank or issuer website.

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