Pauline E. Ranger Good credit depends, in part, on having a healthy mix of loans that you can 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.
Some loans should be excluded from your credit mix. While it may be appropriate to borrow money to buy a house or to have reliable transportation available, not all loans are beneficial. Here are six loans that you should not take out:
401(k), Loans
You may be tempted to borrow against your 401(k), but there are better options than this one. It will take away from the retirement savings you have worked so hard to accumulate.
The 401(k), or retirement fund, loan has a low-interest rate and is tax-free, but the repayments are made with money after taxes, which means you lose out on any earnings the funds would have accrued.
Most plans require you to repay the loan in a short time, usually 60 days, if you lose your employment through a furlough, layoff, or voluntary resignation. Things get more complicated if you cannot repay the loan in an emergency. If you are unable to repay the loan, it becomes more complicated.
Some experts can make 401(k) loans more attractive than other options. But you shouldn’t listen to them blindly. You could have made more money if you contributed to your retirement fund instead of using it to pay off the loan.
Payday Loans
Payday loans usually have a small amount, around $500. These loans are usually repaid in one lump sum within two weeks or one month from the loan date. You are required to repay the loan on your “payday.” You can apply for one of these loans if you receive a regular income from a job or social security payment.
These loans can be very expensive, but they are done misleadingly. These loans usually come with a fee between $15 and $30 per $100 borrowed. People don’t consider the annual percentage rate because it is fixed. Payday loans have 400% and higher APRs compared to traditional ones. Even shorter-term loans come with higher APRs. In states where the maximum cost is not capped, rates are higher.
How is that possible when you only pay $15 per $100 borrowed? Isn’t it 15%? Payday loans are characterized by a short repayment period compared to other types of loans. Due to grace periods, if you borrowed $100 and paid it back within 2-4 weeks like a payday loan, you would probably not pay any fees. If you paid it back in a year, the APR would be around 15%, not 400%, as with a payday loan.
Learn more: How do interest rates work?
The Consumer Federation of America released a report that shows:
In the first year, there is a 50% chance that payday loans will cause defaults.
The risk of bankruptcy is doubled for borrowers
Credit card debt is more likely to be defaulted on by loan borrowers.
Payday loans are not for you.
Home equity loans for debt consolidation
Home equity loans, where you borrow on the part of your house that you’ve paid off, maybe a great idea for home improvement, but they are not a good choice for consolidating debt.
Cashing out your home equity is something you should do with care. You have worked hard for many years to accumulate the asset of your house. Home equity can only be accessed when you sell your home and use the money to buy a new home.
In some cases, you may be able to get a loan against your home equity and use the money for improvements on your property. It can be a good idea if your property’s value increases more than what you borrowed from your home equity. If you are using a HELOC or home equity loan to make substantial improvements to your home, then the interest on this loan can be deducted from your taxes.
It is not a good idea to pay off credit card debt with equity in your home. Home equity loans are cheaper than credit cards and can be used to pay off large amounts of debt. It consolidates many small monthly debt payments into one large payment with a lower rate.
Understand Debt Consolidation Options
This rarely works. After paying off credit cards, people can continue using them while they repay their home equity loans. They need credit counseling after giving up their house ownership and are still in credit card debt.
We advise you never to swap good debts for bad. Mortgages are “good debt” because they allow you to build wealth over the long term. You shouldn’t pay off a “good” debt, like a mortgage loan, with “bad” debts like credit cards.
Related Articles: Good Debt vs. bad debt
You may lose your home to foreclosure if you cannot afford to repay the equity loan. Never put yourself in that situation. Only borrow from your home equity when the funds increase the value of your house.
Title Loans
You can borrow money in the short term by using your vehicle’s title as collateral. These loans have high APRs and are similar to payday loans. Like home equity loans, you can cash out an asset, in this case, your car, to get quick money.
You can lose your vehicle if you do not repay the agreed-upon loan. People can even lose their cars for amounts much less than the vehicle’s value. According to the Consumer Federation of America Report, cited above, half of all car title loans have an APR of at least 300% and are for less than $500. These small loans lead to tens of thousands of cars repossessed yearly.
Auto loans are recommended if you require a reliable vehicle to commute to work. A title loan on a vehicle you own is the exact opposite. You risk your valuable asset in exchange for a quick cash injection at bad terms.
