Personal Loans Are Much Riskier Than Banks Lead You To Believe

Today, you can get a loan for almost anything: vacations, plastic surgery, weddings (and divorces), even Christmas shopping. The names might vary, but all of these loans are really the same product, marketed in different ways.

Personal loans have long been touted as a smart tool for consolidating high-interest debt, but they can be used to pay for just about anything. Want to renovate your kitchen? Take the family to Hawaii? Marry yourself? There’s a loan for that.

Nearly 40 percent of Americans would struggle to cover an unexpected $400 expense, according to a report by the Federal Reserve. So it’s no wonder personal loans are an attractive option for consumers.

But lately, lenders have been pushing personal loans as a way to fund big-ticket, non-urgent “wants.” And they’ve been pushing hard.

“Escape from reality,” one lender prompts. “Get cash for whatever life throws at you,” another promises. With a personal loan, it’s possible to finance any whim.

“Personal loans are often portrayed as a financial olive branch to help individuals pay for large one-time expenses, often to satisfy their desire for instant gratification,” said Logan Allec, a certified public accountant and owner of the personal finance site Money Done Right.

But “the allure of obtaining a personal loan to easily pay for an expensive event gives an individual a false sense of security,” Allec warned. “They can dream big for the moment, but are left paying for it months, if not years later.”

So how did personal loans, once relatively unknown, become the fastest-growing form of lending today?

Personal Borrowing Is On The Rise

Personal loans account for a tiny share of outstanding consumer debt, representing just under 1%. Mortgages make up the majority at nearly 73%, followed by student loans (11%), auto loans (8%) and credit card debt (7%).

However, personal loans have been growing at a rapid pace in recent years, faster than any other type of lending. Last year, the market reached a record $138 billion ― a 17% surge over 2017, according to TransUnion. Personal loans are predicted to grow another 20% in 2019.

While the booming personal loan industry may seem like yet another sign that the economy is improving, there are concerning aspects to the growth. Individuals with less-than-stellar credit scores are often targeted by personal loan companies, according to Allec. “These institutions often brag about their high approval rates and how quickly you can get accepted for a loan,” he said. “What they don’t mention is their sky-high annual percentage rates.”

Indeed, subprime borrowers held an estimated 35.5% of personal loans last year, compared to 19.3% for credit cards and just 3.6% for mortgages. The subprime tier of personal loan borrowers also grew fastest at 4.3% year over year. That means consumers with worse credit and higher chances of defaulting were increasingly likely to be approved for a personal loan.

And as Allec notes, the interest rates on personal loans tend to be quite high unless the borrower has excellent credit. For example, a borrower with a credit score under 630 can expect to pay an average of 27.2% annual percentage rate, according to Bankrate. Fair credit scores don’t get much better, with an average personal loan rate of 21.8% APR ― on par with a typical credit card. Of course, these are just averages; borrowers can pay as high as 36% APR for a personal loan if their credit is in rough shape, according to Allec.

Plus, most personal loans are unsecured, meaning there is no asset to repossess or credit line to revoke should the borrower fail to make their payments. So when times get tough, personal loans are often the debt least likely to be repaid. The default rate for personal loans is higher than other types of major lending at an estimated 3.5% for the fourth quarter of 2018, versus just 1.94% for credit cards and 1.62% for mortgage loans. 

Lenders Push Hard Despite Risk

Even though personal loans present more risk for lenders and consumers alike, lenders are clearly betting on them. 

In particular, financial technology or “fintech” companies such as SoFi, Prosper, Avant and Upstart have increased their stake in personal loans significantly. Five years ago, fintech companies issued just 5% of all U.S. personal loans. Today, that figure is 38%. 

But these companies haven’t discounted low-tech marketing methods. Direct mail, for instance, has remained a successful advertising medium for lenders despite an increasing focus on web and mobile. In May of last year, 368 million pieces of direct mail were sent out by 10 major nonbank lenders tracked by Credit Suisse. That number represented a 10% increase in volume over April, and a 41% rise over the same period the year before.

“Today, there’s an opportunity for banks to offer lending on things that people want, that traditionally they’ve had to save for,” said Leslie Tayne, a debt resolution attorney and author of the book “Life & Debt: A Fresh Approach to Achieving Financial Wellness.” Instead of having to sock away savings for a vacation, wedding or home improvement project, for instance, you can just borrow the money and budget to pay it off. “You don’t have to save ― you can have it right now.”

According to LendingTree customer data for 2018, nearly 62% of borrowers used personal loans for some type of debt consolidation. However, borrowers also used funds to pay for expenses such as home improvements (7.7%), a major purchase (3.5%), vacation (2.3%), a vehicle purchase (1.7%) and wedding expenses (1.5%). A whopping 14.6% of borrowers used the money for reasons simply described as “other.” The average size of these loans ranged from around $5,000 to $12,000, and the average APR was between 22% and 31%.

Fueling Instant Gratification

According to Tayne, most people are unable to save significant amounts of money, whether for an emergency fund, retirement savings or big-ticket purchases. “If you look at the statistics, most consumers are not saving, and they’re not saving enough for the things that they want,” Tayne said. Even when people are able to put some money away, a single financial emergency can leave them right back where they started.

But another piece of the puzzle is a desire for instant gratification. Why save the money over the course of a couple of years when you could have what you want right now? Tayne likened it to the concept of “buy now, pay later,” which gained popularity years ago with the rise of layaway programs. Today, she said, it’s the same idea in a new form. 

However, unlike the traditional programs that were secured by an asset, personal loans are often unsecured debts. “There’s no security interest in a wedding or in a vacation fund,” she said. “There’s definitely a large appeal to those who can’t save or don’t save, and certainly to those who want something now.”

What those consumers may not realize is that while a personal loan might seem affordable from a monthly payment standpoint, it’s not necessarily a good financial move. There can be a number of fees associated with personal loans, such as origination fees, which range from 1% to 8%. Typically, those fees are rolled into the loan balance. So not only do you have to borrow a larger amount to cover the fee, but you’ll also pay interest on it.

For example, say you want to take out a five-year personal loan of $20,000 at 12% APR to pay for a wedding. The origination fee is 5%, which means you actually need to borrow $21,000. Over the course of those five years, you’ll end up shelling out an extra $7,028 in interest on top of the principal. So your $20,000 dream wedding will actually cost you over $28,000. 

Alternatively, you could apply for a credit card that offers an introductory 0% APR and use it to cover the cost, then spend the next 12 to 18 months paying it off interest-free. Of course, that requires you to have a good credit score and the cash flow to pay off the balance quickly. If your finances are in fair shape at best, you’re typically not going to get a great deal on a credit card or loan. At that point, you really have to ask yourself whether it’s worth going into debt, period.

“It’s really important that consumers are aware when they’re researching things like weddings or vacations that a lot of these loan opportunities are going to be marketed to them,” Tayne said. “It’s such a great marketing opportunity for banks, but as a consumer, you have to be aware of what you’re getting yourself into.”