A high-interest loan can increase the cost of borrowing significantly. Depending on the loan amount and term, you could pay hundreds or even thousands of dollars more on such loans. Taking loans with high-interest rates traps borrowers in a cycle of debt that makes their situation worse than before.

But what is a high-interest rate loan and how does it work? More importantly, how do you avoid taking one? We answer all these questions and more in this article.

What is a high-interest loan?

Any loan with an interest rate that’s higher than the national average is considered a high-interest loan. These loans generally have an annual percentage rate (APR) above 36%. This is much higher than the average interest rate of about 8% to 9% on personal loans. Most consumer advocates consider 36% to be the highest APR that is affordable.

High-interest loans may be offered by any type of lending institution including banks, credit unions, and online lenders. So why do these lenders offer loans with high-interest rates and why do borrowers take on these loans? After all, there are loans available with lower interest rates. Both lenders and borrowers have their reasons.

A look at how high-interest loans work

All lenders have a base interest rate that they publish on their websites. However, this is not necessarily the rate that you’ll pay when you borrow money. When you apply for a loan, the lender will first check your credit score. They will then quote you a personalized interest rate based on your score. A high score will earn you a lower interest rate. On the other hand, you’ll pay a higher interest rate if your credit score is 630 or lower. Any score lower than 630 is considered a bad score.

There is a reason why lenders quote different rates depending on your score. A high score indicates that you’re a responsible borrower and make all payments on time. That means you’re more likely to pay their money back on time. Lenders prefer to lend money to responsible borrowers and reward them with lower interest rates. A low credit score means you’ve had problems with paying back your debt promptly. This makes you a high-risk borrower. Lenders are more cautious about approving applicants with low scores because they are more likely to struggle with loan repayments. To offset the higher risk, lenders quote a higher rate of interest. If your credit is bad, you’ll have to settle for loans with high-interest rates.

High-interest loans are usually smaller loans with shorter repayment terms. Loan amounts rarely go above a few thousand dollars and the repayment term may range from one month to a couple of years only. This is unlike student loans and home loans that have higher loan amounts and longer terms of 20 or even 30 years.

Types of high-interest loans

There are a few different types of high-interest loans:

• Unsecured personal loans – An unsecured loan is one not backed by any collateral. Lenders issue unsecured loans based purely on the borrower’s credentials. There is an element to risk in loaning money without any type of security. In this case, too, lenders quote higher interest rates to compensate for the higher risk. These types of loans are offered by banks, credit unions, and online lenders. In most cases, you’ll get the money in less than 24 hours and can use the money for any purpose. This makes unsecured personal loans a great option in case of a short-term emergency.
• Asset-based loans – This type of high-interest loan requires collateral. In this case, the lender will first evaluate the collateral you’re using to secure the loan. This could be your home, vehicle, or any other high-value personal item. The loan amount is limited to the value of the collateral. The interest rates for asset-based loans are only slightly lower than that of unsecured loans. It can be anywhere between 10% and 30%. There’s something you must understand before taking an asset-based loan. The lender can legally take immediate possession of the item you’ve offered as security if you fail to make the payments on time.
• Payday loans – The benefit of payday loans is that the approval process is quick and you’ll get the money immediately. However, this convenience comes at a high price. With an APR of about 400%, payday loans have the highest interest rates among all high-interest loans. You can only borrow around $500 as payday loans and will have to repay the full amount within about two to four weeks. Moreover, these types of loans are only offered in some states.

Risks of taking a high-interest loan

There are definite risks to taking loans with high-interest rates.

Higher interest rates mean you’ll have to pay back a lot more than the amount you borrowed. Even a marginal increase in the interest rate can add up over the life of the loan. By the time you’ve cleared your debt completely, you will have paid much more than the original loan amount.

Most high-interest loans come with shorter terms. This can make the monthly repayments even more difficult. For someone who’s already financially strapped, taking a high-interest loan can make the problems worse. If you can’t afford the payment by the due date, the lender will charge you a penalty. They will also charge high interest on the outstanding loan amount. The late fee penalty together with the additional interest can add up to a lot. This makes it even more difficult to afford the next month’s payments. If you’re not careful, you could get caught in a debt trap with just one late payment.

Advantages to taking high-interest loans

As bad as high-interest loans appear to be, they do have a few advantages. They allow you to get funds quickly in an emergency. This can be especially useful when you need quick cash within 24 hours to meet some urgent costs. Most other loans can take anywhere from a few weeks to several weeks to process.

High-interest loans are also easier to get if you have bad credit and you can’t be approved for regular loans. Lenders that offer loans with high interest generally don’t check credit scores.

If you need fast cash, it helps to get any loan, even if it comes with a higher interest rate. And if you budget properly and look for ways to pay the money back on time, you can avoid the harsher consequences.

State usury laws: you must know!

When taking high-interest loans, it helps to know your state’s usury laws. These are laws that regulate the maximum interest that lenders can charge on a loan. Usury laws were introduced as a way to protect consumers from exorbitant interest rates. Every state sets its cap on the maximum rate of interest that a lender can charge. It’s also known as the legal rate of interest. It’s illegal for a lender to charge interest higher than the limit set in that particular state. It helps to know the maximum rate in your state so that you don’t get ripped off by any lender.

What to look for when taking a high-interest loan

Because of the high risks associated with high-interest loans, it’s important that you understand the terms and conditions before signing any contract. You need to know what the consequences will be should anything go wrong.

The first thing you want to make sure is that you’re taking the loan from a lender that’s regulated by the federal government. It’s best to borrow from a recognized bank or credit union.

Next, you want to check the APR and interest rates and ensure that they are within your state’s maximum limit. If the rate is higher, can the lender justify the higher rates? It’s equally important to check the repayment terms and fees. How much time do you have to repay the money? What are the repayment modules? What happens if you miss a payment deadline? How will the lender handle it if you cannot repay the full amount by the agreed date? Would they charge an increase in the interest rate along with imposing a penalty? Will the lender be able to garnish your wages or repossess your property?

These are all questions you must ask a lender before signing any contract for a high-interest loan.