The Financial Risks Associated With Personal Loans

Lending is a large business in the United States. All told, consumer lending makes up a large portion of the lending industry, which explains why consumer debt levels are so high at over two trillion dollars as of June 7, 2010 according to the Federal Reserve. Since lending is essentially an exchange of debt, it would make sense for a significant portion of lending to result in a significant portion of debt.

While consumer debt is fairly large, the debt owed by the federal government is staggering. As of July 1, 2010, the federal government of the United States owes over thirteen trillion dollars, with eight trillion dollars being held by the public in the form of bonds, according to the Bureau of the Public Debt. This is a large number, but what a discussion of debt fails to take into account about lending is financial risk.

A good portion of consumer lending involves personal loans, which are loans designed to furnish borrowers with liquidity. As the name suggests, these loans are made directly to individuals on the basis of their credit worthiness.

What are Personal Loans?

Personal loans are usually unsecured, which means they do not have any collateral backing them up if the borrower defaults. The loan APR (annual percentage rate) offer amounts are generally determined by your ability to pay and the risk involved for the lender. If you are deemed a high risk candidate for a personal loan, expect a similarly high APR (interest) rate. This makes them risky to the lender, so they stringently check a prospective borrower’s credit history.

Personal loans are not risk-free. Since the lender is basically out of luck if the borrower defaults, they charge high interest rates in order to make up the risk. The interest rates on personal loans are still lower than those of some credit cards, however, which can make them attractive to borrowers.

The high interest rates are combined with a loan term that is fixed and usually non-negotiable. This can be a good thing or a bad thing, since it can make borrowers be prompt and timely in repaying their loan or it can result in the borrower panicking and deciding not to repay the loan if things get a little tight. Obviously the latter option is dangerous to lenders, which ironically is one of the reasons why the fixed loan term is instituted to begin with.

Personal loans are not without risks to both borrowers and lenders. This is why borrowers are counseled to only consider them if they know for certain that they will have the funds to repay the loan.

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