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3 Personal Loan Mistakes You Can't Afford to Make

If you need cash to bankroll a large purchase, you can’t wait to save up for it and you’re not interested in paying credit card interest, a visit to your bank or credit union can be an alternative. Personal loans tend to offer lower rates compared to credit cards and the repayment terms are fixed, which means you won’t have to worry about the debt lingering. When you’re applying for a personal loan, there are some things to watch out for that could make it more expensive.

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1. Overlooking Origination Fees

Any time you apply for a loan, whether it’s to buy a home or consolidate debt, the financial institution extending is likely to charge you an origination fee to process your application. Origination fees are calculated based on a percentage of the amount you’re borrowing. Depending on the lender, it can be as low as 0.5 percent or as high as 2 percent for mortgage loans.

3 Personal Loan Mistakes You Can’t Afford to Make

The origination fee doesn’t always have to be paid upfront. It can be rolled into the final loan total. For example, if you’re borrowing $5,000 with a 2 percent origination fee, the actual amount of the loan could come to $5,100 with the fee. So why is this so important?

The answer is simple – the more you borrow, the more money you’re paying interest on in the long run. A $5,000 loan with a 6 percent interest rate and a five-year payoff could cost you nearly $800 in interest. When you throw in another $100 for the origination fee, it could increase the interest paid by nearly $20. It may not seem like much, but it can add up if you’re borrowing larger amounts or paying a higher percentage for the fee.

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2. Not Asking How the Interest Is Calculated

Aside from shopping around with different lenders to find the best interest rate, it’s a good idea for borrowers to be conscious of how the interest is calculated on their loans. Banks and credit unions can use a few different ways to determine how much a personal loan is going to cost.

With the simple interest method, the interest amount increases based on the amount you borrow, the interest rate and the length of the loan. If you borrowed $1,000 at a rate of 5 percent with a loan term of one year, you’d pay $50 in interest. If the term is extended to two years, the interest would double to $100.

When interest is compounded, it continues to accrue on top of the existing interest as you pay down your balance. Compound interest can be calculated on a daily or a monthly basis but you can shave off a few bucks if you make additional principal payments each month or pay ahead of the due date.

If your loan interest is pre-computed, it’s already built into your monthly payment amount. Every time you pay something toward the balance, a specific portion of it goes to the principal and the rest goes to cover the interest and finance charges. If you’re planning to pre-pay on the loan or knock it out early, you don’t stand to save as much on interest if it’s computed beforehand.

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3. Not Checking for Penalties

3 Personal Loan Mistakes You Can’t Afford to Make

Although it’s not usually associated with personal loans, some lenders may include a prepayment penalty clause in your contract. Basically, that means you’ll have to hand over more cash to the bank if you decide to wipe out the loan ahead of schedule. Also called an exit fee, the prepayment penalty is designed to make up for the interest the bank is losing out on. Before you sign on the dotted line, it’s probably best to review your loan contract carefully to check for any hidden fees like this that could end up costing you money.

Photo credit: ©iStock.com/IPGGutenbergUKLtd, ©iStock.com/Zerbor, ©iStock.com/LUHUANFENG

Rebecca Lake Rebecca has been writing about the nuts and bolts of personal finance since 2009. Her work has appeared on a number of popular finance sites, including the Quickbooks/Intuit small business blog and Money Crashers. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.

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