The Worst Mistakes You Can Make When Taking Out a Loan | The Motley Fool (2024)

Most of us have to borrow money at some point, whether that's an auto loan to buy a car or a mortgage to purchase a home.

Borrowing can help improve your financial situation if you are able to keep on top of payments. Loans can help you grow your net worth and build credit. But they can also become hard, or even impossible, to manage, if you make certain borrowing mistakes. In fact, some errors you could make when taking out a loan could devastate your financial security for years to come.

If you take out a loan, you don't want it to have an adverse impact on your financial life. Be absolutely certain you avoid these three borrowing mistakes.

1. Borrowing money you cannot afford to pay back

If you aren't 100% sure you can make payments on a loan you're thinking of taking out, just say no to borrowing. Don't plan on your income increasing later. This could lead to major financial trouble.

Missing even one payment could damage your credit score for many years to come. That could make every loan you take out more costly or prevent you from getting the credit you need. And defaulting on a loan could lead a creditor to pursue collections efforts. They might sue you and garnish your wages or get a lien put on your property.

If you've taken a mortgage or a car loan and can't pay it back, you could end up dealing with foreclosure or repossession -- and you could lose the money put into your home or vehicle. Your credit could be damaged for a decade, too.

Always look at your budget before borrowing and make 100% sure that your new loan payment is comfortably affordable. If you have even a shadow of a doubt about whether you'll be able to make payments on the loan during the entire time you're borrowing, don't take out the loan.

2. Borrowing money at too high of an interest rate

The higher your interest rate, the higher the cost of borrowing and the harder it is to repay your loan. That's because more of your money will go toward interest so your principal balance will decline slowly.

You're also committing to a big financial obligation, which could make it harder for you to live on a budget or accomplish other financial goals. Borrowing at a high rate also cuts off your options in the future. You might not be able to switch to a job you'd prefer if you'd have to take a pay cut, for example.

Since getting the lowest interest rate possible is so important, shop around and get quotes from multiple lenders before you borrow. It's worth the effort to look carefully at different loan terms and compare rates from at least three lenders. You never know when one loan provider may offer significant savings compared with its competitors.

3. Taking out a loan you don't fully understand

When you borrow, you need to know:

• The monthly payment
• Whether your payment could go up, how often it could go up, and what could trigger its rise
• What your maximum payment amount would be if your payment went up
• When you're expected to repay your loan in full
• The total interest you'll pay over the life of the loan
• Whether you're subject to prepayment fees or penalties if you pay off the loan early or refinance it

If you don't fully understand the terms of your loan, you could end up with a variable-rate loan that becomes unaffordable down the road or a loan that requires a big lump-sum payment. Or you could end up stuck in a loan that you can't really afford and can't get out of. And this could lead to financial disaster.

Many people ended up with mortgages they didn't understand in the lead up to the 2008 financial crisis, and millions ended up in foreclosure or almost lost their homes because of it. While this is an especially big problem with mortgage loans, you should know the details of any borrowing you do -- even if you're just signing up for a credit card.

If you understand your loan, you can make an informed choice about whether it's the right financial move for you.

Avoiding these mistakes is key to financial success

If you can avoid these borrowing mistakes, you should be able to stay out of serious debt trouble. Your debt can be a tool that helps you accomplish your goals rather than an albatross around your neck that makes money management impossible.