Good credit depends, in part, on having a healthy mix of loans that you are able to handle successfully—something like a mortgage, auto loan, and a small credit card balance would boost your credit mix and help you establish your creditworthiness.
There are some loans, however, that should never be part of your credit mix. Even though it might be appropriate to borrow to own a home or have reliable transportation, not all borrowing has an upside. Here are six types of loans you should never get:
Loans taken out against your 401(k)-retirement account may seem like an easy route to take, but you should consider other options first because they attack the retirement savings you’ve worked very hard to build up.
It’s true that 401(k) loans carry a relatively low interest rate and are tax free money, but you repay the loan with after-tax dollars, all while you are losing out on the earnings those retirement funds are supposed to be accumulating for you.
If you lose your job either through a layoff, furlough or a voluntary resignation most plans require that you pay off the loan within a short period of time, typically 60 days. In the unfortunate event you can’t repay the loan, it gets more complicated. In this case, the money you took out is considered a hardship distribution, and you will be required to pay taxes on the unpaid balance and an early withdrawal fee.
There are some experts who can show you math that makes 401(k) loans look better than other options, but you should not thoughtlessly listen to them. The money you pull together to repay this kind of loan could have earned more for you if you had contributed it to your retirement account rather than used it to get out of the hole the debt created.
Payday loans are usually small, averaging under $500. These kinds of loans are repaid with one payment, usually within two weeks to one month of when the loan was given. On “payday”, you are expected to pay back the loan in full. If you have a regular income, whether through a job, social security check or pension, you can get one of these loans (assuming they are legal in your state).
These loans are very expensive, but in a deceptive way. Typically, one of these loans might come with a fee of $15 to $30 for every $100 borrowed. Because the cost is fixed in this way, people don’t think of it in terms of an annual percentage rate (APR). If you calculate it compared to traditional loans, the APR for a payday loan is near 400% or higher. Shorter term loans have even higher APRs. Rates are higher in states that do not cap the maximum cost.
How can that be, if you’re only paying a fee of $15 for every $100 borrowed? Isn’t that 15%? It’s because payday loans have a very short repayment schedule relative to other loans. If you borrowed $100 by shopping with a traditional credit card and paid it off within 2-4 weeks like a payday loan, you’d probably pay no fees or interest due to grace periods. And if you took a full year to pay it off, you’d pay around 15% APR, not 400% like a payday loan.
The Consumer Federation of America published a report showing that:
- Payday loans have a 50-50 chance of causing defaults in the first year of use
- They leave borrowers twice as likely to file for bankruptcy
- Loan borrowers are more likely to default on their other debts, like credit cards.
Just say, “no” to payday loans.
Home Equity Loans for Debt Consolidation
This is a tricky one, because home equity loans—where you borrow against the part of your home that you have paid off—may be a good idea for home improvements, but you should avoid them for debt consolidation.
You work hard over many years to build up the asset that is your home, and cashing in those funds is something that should be done with great care. Typically, the only time you’ll cash in home equity is when you sell the home and put that money into the next home you buy.
There are some cases where you might get a home equity loan and use that money to improve your property. This can make good financial sense if the property increases in value more than the amount you borrowed against your home equity. As a bonus, if you use home equity loans or a HELOC (Home Equity Line of Credit) to substantially improve your home, the interest paid on that loan is tax deductible.
What doesn’t make financial sense is paying off credit card debt using equity from your home. People do it because home equity loans are less expensive than credit cards, and they can usually pay off a lot of debt with one big home equity loan. This consolidates a lot of small debt payments into one larger monthly payment at a lower interest rate.
Learn More: Understanding Debt Consolidation Options
That said, this seldom works out. Once people pay off their credit cards, they are free to use them, all while trying to pay off their home equity loan. They end up needing credit counseling because they’ve given up their ownership in their home and still end up with credit card debt.
Our advice is to never trade good debt for bad. Mortgages are “good” debt, in that they help you build wealth over time. Don’t use a good debt like a home loan to pay off “bad” debts like credit cards.
Related Articles: Good Debt Vs. Bad Debt
The worst-case scenario is one where you can’t afford to repay the home equity loan and you end up having to sell your house or lose it to foreclosure. Don’t ever put yourself into that position—never borrow against your home equity unless those funds are earmarked to make the home worth more money.
An auto title loan lets you borrow in the short term by putting the title to your car up as collateral. Like payday loans, these loans are short term and have a very high APR. And like home equity loans, you cash in an asset—in this case your car—in exchange for quick funds.
The risk is great, as you can lose your car if you don’t repay as agreed. Even worse, people can lose their car over an amount much lower than the car’s value. In the Consumer Federation of America report cited above, it states that half of car title loans are for $500 or less, and come with an average APR of 300%. Tens of thousands of cars are repossessed every year because of these small loans.
We stress the importance of preserving your ability to earn an income, so if you need a reliable car to get to work, an auto loan is warranted. But getting a title loan against a car you already own is the opposite—it’s risking an important asset for a short-term infusion of cash at very bad terms.
You use credit cards to make purchases, so why not use them to get cash? Because it’s a terrible idea. Cash advances aren’t like withdrawing money from the bank. This is a loan, and one that is very expensive and too easy to get.
If you get a cash advance, you’ll be charged a fee up front, typically up to 8% percent of the amount you borrow. Then you pay interest on the debt that is higher than the regular interest rate for credit card transactions. On average, the interest rate for cash advance balances is around 7% higher than the normal rate for purchases.
The downsides don’t stop there. Cash advances don’t have a grace period like purchases do—you’ll start paying that extra-high interest from day one until you pay off that balance.
You typically get cash advances using an ATM, but those checks that your credit card company sometimes sends you are the same loan product, and carry the same bad terms. Shred those checks immediately when you get them, and don’t get a cash advance through your credit card company for any reason.
Personal Loans from Family
It should be obvious how many ways this kind of loan can go wrong. When you borrow from your loved ones, your failure to repay can damage the most important relationships in your life.
Worse, it’s more likely you’ll fail to repay, because your family members will be unlikely to pursue collections as aggressively as a traditional lender. That leads to lax repayment schedules, which only increases the tension.
In the age of social media, your family will probably see pictures of you online where you are enjoying yourself. Every vacation you take, every concert you go to, every activity that people like to document and share will be a trigger for the people who loaned you money. Think very carefully about how you would feel if you had loaned any of your friends and family money based on their online presence.
If you are considering borrowing money from a family member, stop and assess your situation. Have you reached the point of desperation where you see no choice but to risk your relationship by asking for money? What got you into this kind of financial trouble? Doesn’t your family member deserve to know, before they give you the funds?
If what you need the money for is too embarrassing or difficult to talk about with family, then it’s a bad idea to ask them for this loan. Address the root causes of your financial situation, rather than applying a band-aid in the form of more debt.
If you’re thinking of getting one of these kinds of loans, talk to a debt coach first, and see if there’s a better solution. Work to pay off your existing debts and build good credit so you have access to reputable loan products at reasonable rates. Don’t put your home, car, retirement or family relationships at risk when there are better ways to reach your financial goals.