The return of easy money
Though it happened more than a decade ago, the 2008 financial crisis—spurred on by a spate of risky lending—is still a fresh national nightmare. In its wake, the government cracked down on these lending practices with tighter scrutiny, new regulations (Dodd-Frank, anybody?), and the creation of the Consumer Financial Protect Bureau (CFPB).
Well, guess what? Just a dozen years later, a new group of dodgy lenders has cropped up. And while all loans come with strings attached, this growing variety of easy-money can tie you up in financial knots.
As wages rise slowly relative to costs in key areas like housing and health care (despite upbeat employment numbers), there’s a growing—and worrisome—trend of consumers resorting to newfangled borrowing options to make ends meet. Here are three types of loans rising in popularity, and why you should be wary of them.
Online personal loans
The term online personal loans is shorthand for a range of easy money options, including: networks (also known as marketplace lenders) that connect lenders and borrowers on a peer-to-peer basis; apps that give you an “advance” on your paycheck; and traditional banks that approve loans online (often quickly) instead of in an office. Another new and disturbing entrant: online installment loans.
To understand this product, you must first understand its older cousin: payday loans. Those generally require repayment of the full amount plus interest within weeks (typically the borrower’s next payday). Their interest rates are exorbitant even under caps that vary by state. Ohio’s interest cap is a mindboggling 677%.
With online installment loans, many of the old payday lenders have schemed a way around the regulation (and stigma) of payday loans. At first blush, installment loans look more reasonable—they are repaid via monthly payments ranging from a few months to several years—with interest rates generally up to 30%. But state laws allow the sale of unnecessary credit insurance to go with the loans, as well as expensive upfront “loan origination” fees of 5% or more that significantly boost the effective interest rates of the loans.
And as the financially vulnerable turn to these loans to cover expenses when money is tight, analysts like Margot Saunders—senior counsel at the Boston-based National Consumer Law Center, a consumer analysis and advocacy group—are concerned. “[They] are almost always dangerous, likely unaffordable, and cause much more trouble than the immediate advance of the money will resolve,” Saunders said.
Even when the rate seems reasonable, watch for hidden fees and fine print designed to keep you hooked. If you need money to tide you over between paychecks or for tackling an unexpected emergency expense, explore other options:
- Find a nonprofit offering zero-interest loans, such as the IAJFL.
- Seek credit counseling at an accredited and certified agency. To find one, visit the NFCC.
- Get a secured credit card to build up your credit and eventually get a loan on better terms. (Try com to get a list of the best deals.)
- Ask your employer if it offers loans against future paychecks to help smooth income gaps and volatility.
Non-qualified mortgages (Non-QMs)
If you’ve shopped for a home lately, you may have heard of “qualified mortgages.” These loans follow rules created by the CFPB that eliminate risky features like interest-only payments or repayment periods exceeding 30 years. In an ideal world, these are the loans you want. But non-qualified mortgages (non-QMs), which aren’t bound by the same regulations, still exist and are increasing in popularity.
Non-QMs can reach borrowers deemed too risky for a qualified mortgage—for example, freelancers without a regular paycheck or people whose student debt makes their debt-to-income ratio too high to make them eligible for a qualified loan. “Just because it’s a non-QM, doesn’t necessarily mean it’s a bad idea,” Saunders said. But you need to be aware of the risks.
Terms that seem too good to be true may be trying to distract you from pitfalls, such as ballooning payments: “They could have a teaser rate to begin with, but once that rate ends, the payment would be much higher,” Saunders warned. Others might have payments that go toward your interest only, without even reducing the principal—a practice that’s prohibited in a qualified mortgage.
So if your circumstances require you to look at non-QMs, shop for the best rates, which in general tend to be higher than those of standard 30-year, fixed-rate mortgages. But also pay attention to how the terms may change over time. And try to be mindful and conservative about how big a loan you can afford to take out; don’t rely solely on a non-QM lender’s evaluation. To do that, I like NerdWallet’s “How Much House Can I Afford?” calculator.
Long-term auto loans
To make today’s new cars appear more affordable, dealers have been offering longer-term loans. This means monthly payments are lower, but the overall cost (with interest) to the buyer is greater. A growing share of new-car buyers—now almost a third—are taking out loans of six years or more, and that couple of extra years could cost you thousands of dollars. Say you bought a $35,000 car with a $5,000 down payment. Paying it off over three years at 4.5% interest would cost you $32,127 via monthly installments of $892. The same loan over six years would reduce monthly payments to a tempting $476, but would end up costing you a total of $34,288—a difference in additional interest of more than $2,000.
“Will the car still be drivable when you finish paying the loan?” Saunders asked. Although cars can last a decade, most people keep them for about six years, so a six-year loan might leave you with a ride so outdated it isn’t worth what you still owe on it.
One solution might be a lightly used car, plus a goal of taking out a loan of four years or less (if you can afford the payments). And make sure when purchasing that you first negotiate the price of the car only; don’t allow the dealer to talk financing or the size of your monthly payments before you get the best price you can on the car itself. (To check for the vehicle’s fair asking price, use Kelley Blue Book.)