What is the risk of a personal loan for Canadians?

It’s virtually impossible to go through life and not have at least one occasion where having a bit more cash in your pocket wouldn’t have been beneficial.

Whether you’re close to getting that new car or need to take care of some long-overdue repairs to your home, having access to additional money can make life a whole lot easier. To get that extra money, you’ll either need to earn more at work (which can be difficult or impossible) or take out a loan.

Personal loans are an important part of the economy as they provide Canadians with a crucial financial resource. But while there are definite positives to using personal loans, there are also some major risks to these financial products.

In this article, we’ll discuss a few of the things to consider before taking out personal loans, including some of their many potential risks, which could lead to financial trouble if you’re not prepared.

What is a Personal Loan?

So-called personal loans are actually a broad category of credit that includes a wide array of different financial products that we have a tendency to lump together.

These loans range in size from just a few hundred to tens of thousands of dollars, and they can offer many different term lengths and interest rates to consumers. Personal loans are used to fund just about everything and anything you can think of, including car repairs, new appliances, services, construction, bills, vacations, and regular ol’ consumer spending.

You can get a personal loan from a traditional banking institution, a payday or title lender, or increasingly, an online lender. If you need a personal loan, you’ll apply for the line of credit and agree to the terms of repayment.

Once you finalize your loan, the lender will normally deposit money into your bank account. Some lenders will require the use of a prepaid debit card to transfer your funds, while others may give you cash.

When you repay the loan, you’ll pay back the principal (the amount you borrowed) and interest (the cost of borrowing the money). The amount of interest you pay varies widely depending on the type of loan you’ve taken out and your creditworthiness.

Like all loans, personal loans can be broken up into two broad categories:

• Secured – A secured loan is one that’s backed by collateral. For example, a home equity loan is secured by the value of your house if it is sold. Secured loans tend to have lower interest rates and are available to a wider variety of people. This is because the bank or financial institutions views them as more secure. If you fail to pay the loan, the bank can recover your debt by taking your collateral as payment. Other common types of secured loans include auto financing loans.

• Unsecured – An unsecured loan is the exact opposite of a secured loan—it’s not backed by collateral of any kind. Instead, the bank gives you money with nothing more than a promise that you’ll repay. This doesn’t mean the bank can’t collect the debt if you fail to pay. Rather, a lender can send your debt to collections or take you to court and sue for the value of your loan.

Most personal loans are also closed-ended, which means you borrow a predefined amount of money, and when it’s paid back, the loan is closed. This is in contrast to an open loan, like a credit card, from which you can borrow over and over again so long as you pay off your statement balance.

General Risks of Loans

Before we dive into specific loans and the different risks you might face with each kind of personal loan, let's look at some of the broader risks that come along with borrowing money. Some of these risks are pretty straightforward while others may surprise you. Here’s what you need to know.

Borrowing More Than You Can Repay

Perhaps one of the most prolific risks with personal loans is borrowing more money than you can pay back.

When you’re considering borrowing money, take a close look at how much you bring in with each paycheque and how much you’ll need to pay out for things like rent and other bills.

The amount remaining is the amount you might be able to use to repay a loan. But always remember that you might have to deal with other expenses over time that could prevent you from repaying your debt.

Can Trap You in a Cycle of Debt

If you get used to taking out loans every time you need some cash, you could quickly find yourself stuck in a cycle of debt that’s hard to get out of.

This is particularly true if you open a loan that lets you “roll over” debt from another line of credit. Over time, you may find that you inadvertently took out more debt than you can afford to repay and you’ll be stuck paying off your loans for years to come.

That’s why it’s important to only take out a loan if the money is going toward a useful purpose and if you’re confident that you can repay your debt.

Not Borrowing Enough

If you’re using a personal loan to fund something like construction on your home, you should consider whether the amount you’re seeking is enough to cover the full cost of your future payments.

Construction is notorious for hidden costs and delays. If you do plan to borrow money for home improvements, be sure that you can afford to cover the costs of any unintentional expenses that may arise during construction.

Hidden Fees, Charges & Loan Terms

As is the case with any kind of contract, make sure you understand both the bold and fine print in anything you sign when it comes to loan agreements. Not understanding something is not an excuse or a way out of a loan.

There are laws that protect consumers from many predatory elements of loans, but there are also some legal practices that have a tendency to confuse consumers. Take a close look at the interest rate, how much you’ll pay each month and any fees or charges you might face. Consult a financial advisor if you need more specific advice about your loan agreement.

Compounding Interest

By law, lenders cannot charge you more than 60% per year in interest for your loan. It’s important to remember, though, that interest usually isn’t calculated or compounded annually but instead, is often calculated daily. The interest rate you pay is also completely reliant on when you actually repay your loan, too.

So, if you borrow $100 today and repay $101 in one year, the annual percentage rate is 1%. If however, you repay that $101 tomorrow, the APR is 365%. In short, the interest rates you see advertised can sometimes be a bit misleading.

It’s important that you look carefully at any potential loan product, the projected monthly payment, and the total amount you’ll pay over time before you agree to take out a loan. Ensuring that a loan fits within your budget is critical if you want to lower your chances of getting into long-term debt.

Different Kinds of Personal Loans & Their Risks

There are many types of personal loans out there, but let’s look at a few of the more common personal loans you might come across in Canada and some of the risks associated with them.

Hard Money Loans

Hard money loans are non-traditional personal loans that are almost always secured. You can take them out for nearly any legal purposes (lenders might have restrictions on using funds for gambling or investing) but they’re only provided by non-traditional lenders, like pawn shops.

With hard money loans, you can walk into a lender’s office, ask for a loan of $1,000, provide collateral, and walk out with cash. People often use these types of loans for a variety of different things, from business expenses to adding an addition on a home.

Since hard money loans are non-traditional, they’re typically only used by people who are deemed “high-risk borrowers” by lenders. They tend to have higher interest rates and lots of hidden fees. If you don’t pay back a hard money loan, you will likely lose your collateral.

Debt Consolidation Loans

If you’ve got a number of different loans or credit cards with varying or higher interest rates, you can often consolidate that debt into a debt consolidation loan.

These loans provide you with one easy monthly payment that may have a lower interest rate than your original debt. Debt consolidation loans can be extremely helpful if you want to rebuild your credit and pay off large amounts of debt in a short period of time.

The main risk of debt consolidation loans is that, if you don’t change the money habits that led you to debt in the first place, you may not be able to get out of the debt cycle. Also, if you take out one of these loans, always make sure that you understand the terms of your agreement and what fees you’ll be charged.

Payday/Title Loans

Designed to be repaid with the next paycheque, payday and title loans are ultra-short-term lending instruments that provide a quick infusion of cash for emergencies.

They are not designed to be used for a long period of time because interest rates can hover above 500% (this is higher than the federal limit on interest rates because payday lenders are normally exempt from these restrictions). Moreover, payday and title loans—the latter of which are tied to your vehicle as collateral—tend to trap people in cycles of debt.

When you take out a payday or title loan, you’re often required to pre-authorize the company to take money from your bank account. If you do not have money in your account when it’s debited, not only will you not repay your loan, but you may be subject to fees for overdrawing your account.

Buy Now, Pay Later

You’ve probably seen “Buy Now, Pay Later” on the checkout screens of websites everywhere but you may not have realized that this feature is an increasingly popular type of personal loan. Buy Now, Pay Later services allow you to break up your larger purchase into a few smaller payments, all without interest (if you pay back your debt on time).

The risk of these services is that they might run a credit check on you when you make a purchase. If you don’t pay your installments on time, you may be subject to interest or late fees. Should you default on your debt, it will also likely get sent to collections. Plus, the convenience of these tools increases your risk of borrowing more than you can repay.

Personal Loans: Useful, But Not Risk-Free

A personal loan can help you pay for a wide range of different products and services. When used wisely, personal loans may be very helpful financial tools, but as is the case with most things, they’re not without their risks.

The biggest risk of personal loans is that they can trap you in a cycle of debt if you end up borrowing more than you can actually afford to pay. These loans also tend to have fairly high interest rates and they may have hidden fees and conditions.

Always do your due diligence when taking out a loan so that you know what you’re signing up for. If you have specific questions or need help with your loan application, consult a financial advisor, and use a loan comparison platform like Loans Canada.