High-Interest Loans: What They Are and How They Work

Loans, Personal Loans, Unsecured Loans

Whether you need an emergency loan, auto repair financing or funds to pay for moving across the country, the number of loan options available can feel overwhelming.

And if you need cash fast, have bad credit or have a high debt-to-income (DTI) ratio, a high-interest loan may be your only option.

High-interest loans are usually seen as having caution tape all over them, but it doesn’t always mean bad news for you.

We’ll break down everything you need to know before deciding if a high-interest loan is right for you.

What Is a High-Interest Loan?

A high-interest loan can be any loan with an interest rate above the national average. Lenders may offer high-interest loans because borrowers need money quickly, or because they have bad credit scores (below 579) or a high debt-to-income (DTI) ratio (above 43%).

Most high-interest loans are unsecured (although not always) or have short-term repayment periods ranging from 1 month to a few years.

If an unsecured loan isn’t backed by collateral, lenders tend to issue higher interest rates compared to secured loans like mortgages or auto loans. Unsecured loans also tend to come with shorter repayment periods that tend to drive up interest rates.

What are the risks of a high-interest loan?

While you may not set out looking to get a loan with a high-interest rate, if you’re in need of cash fast, you may opt for a loan offer that ends up creating more financial trouble for you in the end. Be aware of some signs that a loan may come with a high interest rate, like:

  • No credit checks
  • Easy application
  • Quick financing
  • Secured with high-value collateral in a practice called equity stripping

Each state has their own usury laws that regulate the highest interest rate lenders can offer depending on the type of credit. It’s called the legal rate of interest. When a lender offers an interest rate that goes above the legal rate of interest, they’re called unlawful loans and the lenders can face strict penalties.

However, usury laws are confusing and often full of exclusions and loopholes that allow lenders to charge interest rates above the legal rate of interest and still offer legal loans. In some cases, borrowers may also be able to waive the protection usury laws provide in order to receive financing.

Types of High-interest Loans

High-interest loans aren’t confined to a specific box of loan types, you can have a high interest rate on any loan ranging from reputable secured loans like home equity loans or auto loans to predatory loans like payday loans. But these are some of the most common types of loans likely to have high interest rates.

Unsecured personal loans

Unsecured personal loans are installment loans offered by banks, credit unions and online lenders for borrowers with both good and bad credit scores. They can be used for pretty much anything, you may be able to get the money in as little as 24 hours and most lenders offer up to $50,000.

You then make fixed monthly payments over the course of 1 – 5 years. Interest rates range from 5% – 36% based on your income and creditworthiness.

However, if you have bad credit and the loan charges a higher-than-average interest rate, you might see these advertised as “bad credit loans.”

Payday loans

Payday loans are small loans that get you cash fast but the loan amount is usually limited to around $500 and these loans come with sky-high fees. You’ll usually have 2 – 4 weeks to repay your loan (or whenever your next paycheck is) and fees can equate to an annual percentage rate (APR) of 400%.[1] Payday loans aren’t offered in all states.

Payday alternative loans (PAL)

These loans are similar to payday loans but offered by credit unions up to $2,000 and you have more time to repay the loan – usually up to 12 months.[2] The National Credit Union Administration regulates PALs and sets limits on fees and interest rates. As of 2019, the maximum APR is 28%.[3]

Asset-based loans

While most high-interest loans don’t require collateral, some do. With these high-interest loans, a lender offers a loan based on the value of the collateral you use to secure the loan, such as your home or car.  Some of these loans like auto title loans can charge between 10% – 30% interest and if you miss payments, the lender can take immediate possession of your home or car.[4]

Know the Risks of High-interest Loans

High-interest loans come with both benefits and drawbacks, and some might say the cons outweigh the pros. We’ll let you decide.

Borrow small amounts of cash when needed

May be easier to get than credit cards or other types of loans if you have bad credit

High interest rates and fees can mean paying a lot more than what you borrowed in the first place

Shorter repayment terms can cause trouble if you’re already financially strapped

Can get caught in a debt trap if you can’t repay the loan and fees by the due date and have to carry the balance over

How High Is Too High for Interest?

Usury laws aside, you might be asking, what number is considered too high for an interest rate? While we can’t give you a specific number, we can say an interest rate that falls above the national average may be considered “high.”

But remember that the interest rate you’re offered depends on your credit scores and DTI. So it’s not uncommon to see an interest rate well above the national average if you have bad credit.

As we mentioned before, the average interest rate for an unsecured personal loan is approximately 8% – 9%.[5] That being said, interest rates for unsecured personal loans can be upwards of 36%, depending on how low your credit score is.

Since payday loans, asset loans and PALs usually come with the set APRs that we mentioned above, we aren’t quite able to say what is “too high.” But some states set laws that prohibit payday lenders from exceeding a certain amount in fees.

Know what to look for with high-interest loans

Keep in mind that a high interest rate doesn’t always mean you can’t afford to repay the loan. Make sure you read the loan agreement to know exactly what your loan terms are and how much the loan is going to cost you before signing.

The main things you’ll want to look for are:

  • Type of lender: Are you getting your loan from a bank or credit union that is insured and regulated by the federal government or an unregulated lender?
  • APR and interest rates: Are they higher than other advertised rates and if so, by how much? Can the lender provide you with a reasonable explanation as to why the rate is higher?
  • The repayment terms: How much time do you have to repay the loan? Also, does the loan offer loan payments with fixed installments or an interest-only model where you pay less during the repayment period but have a larger payment at the end of the loan period?
  • Fees: How much does the lender charge in fees? How much does that add to your total debt? Are the fees due upfront, added to the loan balance or due at the end of the loan period?
  • What happens if you default: If you can’t repay the loan by the due date, will you need to pay a penalty or does the interest rate increase? Also, does the lender have the right to repossess your property or garnish your wages?

What Are Alternatives to High-Interest Loans?

If you’re in a crunch for cash, have bad credit or a high DTI, some alternatives to high-interest loans are:

  • Credit union loans: If you can become a member of a credit union, you’ll likely get lower interest rates on loans because they also look at their relationship with you, not just your credit report, when determining interest rates. Federal credit unions cap their interest rates at 18%.[6]
  • Cash advances: These are like loans through your credit card issuer; they allow you to borrow money against your credit card balance and get cash right away at an ATM or bank. But you could be charged a host of upfront fees and interest starts accruing immediately – usually at a higher rate that you’d normally pay for credit card purchases.
  • Employer cash advance: Ask your employer if they can offer a payroll advance if you need money for something quickly. Your employer will loan you the money against your future paycheck. So remember, that money will be deducted from your wages.
  • Credit cards: If you’re struggling financially, using a credit card for unexpected expenses may not be the best move, but it is an option. Interest rates can also be high, possibly higher than the loan you’re looking at. But if you can pay off your balance before the statement due date, you may be able to avoid paying interest.
  • Assistance programs from local nonprofits: Doing a Google search of “local nonprofit financial assistance programs” can provide you with a hefty list of state, city and local government resources as well as local nonprofits that can help you in times of need for a variety of reasons. Just make sure you research them thoroughly to make sure they’re legit and not a scam.

Avoiding These Is In Your Best Interest

High-interest loans can be tempting when you’re in need of cash now or your credit history is a little lackluster. And if the only loan you qualify for has a high interest rate, you’ll want to make sure you know what the loan is going to cost you.

Before you agree to a high-interest loan, check to see if there are other financing options available to you that are less risky.

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