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Adding a new credit card to your wallet, taking out a car loan or filling out the paperwork for a mortgage can be exciting steps toward reaching your financial and life goals. But while doing so may not feel particularly daring, anytime you take on a new form of debt, you also take on risk. Making all your payments on time helps keep these risks at bay, but if you take on more debt than you can afford you may not only face late fees, but damage to your credit score—and in some cases, loss of your car or home.
Some borrowing risks are present across all types of debt, while other concerns are specific to certain types of accounts. Before you apply for a new loan or credit card, learn how to reduce your risks and borrow safely to protect your credit and finances.
Why Borrowing Money Is Risky
The positives of borrowing money are clear in certain instances: It may allow you to attend the college of your dreams or help you buy your first home, for example. But having a new debt you need to make payments on can also create extra financial risk. Here are some of the dangers tied to borrowing money:
- Damaging your credit: Whether you have a loan or a credit card, making late payments or missing payments can cause your credit score to fall. This matters because your credit is considered nearly anytime you apply for a new loan or credit card, and could be considered when you apply for a rental property, utilities and even a new job.
- Extra costs: If you use your credit card but don't pay off the balance every month, you'll pay interest on the charges—which could add up to thousands of dollars over time if you're not careful. You could also incur other costs such as late fees if you're late on a payment. These may be small, such as $25 for a late credit card payment, but these penalties can add up.
- Taking on too much debt: It's easy to get in over your head with debt, whether it's from running up credit card balances or trying to manage several loans at once, such as a student loan, car loan and mortgage. If your income can't cover both your debt payments and ongoing expenses, you may get trapped in a cycle of debt.
- Going into collections: If a debt goes unpaid for a long stretch, it may go into default and then into collections. Not only does this process further damage your credit, but it can be immensely stressful dealing with debt collectors and trying to figure out a path forward.
- Losing your collateral: With secured loans, you run the added risk of losing your collateral, such as a car or home. This isn't the case with unsecured loans, such as a personal loan or student loan, since there's no tangible object a lender can repossess from you.
- Wage garnishment or bankruptcy: Regardless of whether your debt is secured or unsecured, in the worst-case scenarios, consistent failure to pay could lead to the lender securing wage garnishment against you. Or, you may have no other choice but to declare bankruptcy, which causes lasting damage to your credit. These serious consequences can make it very difficult to get back on track with your financial goals.
Risks of Using Loans and Credit Cards
Certain types of debts carry unique risks. Here's what you need to know before you borrow money in the form of a car loan, mortgage or credit card.
Car Loans
A car loan is a secured loan, where the vehicle you purchase serves as collateral for the lender. This reduces risk for the lender, so it may be easier to get approved for auto loans—and also enjoy lower interest rates—than with an unsecured loan.
On the flip side, this means if you stop making your payments, the lender may eventually repossess their loan's collateral and leave you without a car. Not only that, but once a lender has repossessed a car, it goes on your credit report as its own negative mark and remains there for seven years. During this time, the repossession as well as the missed payments leading up to it will bring down your score and make it more difficult to get approved for other loans and lines of credit.
Mortgage Loans
A mortgage is another form of a secured loan, where the home serves as collateral to the lender. This keeps mortgage interest rates low compared with unsecured forms of borrowing, but it also means that defaulting on your loan can put you in danger of losing your home.
Getting behind on your mortgage payments doesn't necessarily mean you'll experience foreclosure. Some lenders will permit a mortgage forbearance, which allows for temporarily reduced or suspended payments during a hardship. The federal government also offers some mortgage relief programs and recommendations, currently including those related to the COVID-19 pandemic.
In general, if your mortgage goes unpaid for more than 120 days and you haven't qualified for any form of relief, foreclosure becomes an option under federal law, according to the Consumer Financial Protection Bureau. If a lender proceeds with the legal foreclosure process and succeeds, you will lose the home. A foreclosure also remains on your credit report for seven years, so it can cause lasting damage to your credit and future ability to borrow money.
Credit Cards
Making late credit card payments can cause you to get dinged with late fees, and falling behind on payments can endanger your credit just as it does with any other form of borrowing. But there's a unique way your credit card use can pose a risk to your credit and finances.
When you take out a loan, you borrow a set sum of money that you repay over a term with an end date. Conversely, a credit card is a form of revolving credit, which gives you a line of credit that you can borrow from over and over again up to your credit limit.
Just because a credit card issuer gives you a certain credit limit doesn't mean you should use it all, however. Because you're given a line of credit to use freely (sometimes a surprisingly large one), it can be easy to rack up charges you can't afford. Credit cards have some of the highest interest rates for borrowing money, so if you're not careful, you may find yourself struggling to pay off the card and get ahead of the mounting interest charges.
Credit card misuse not only jeopardizes your finances and risks trapping you in debt, but it also damages your credit. Your credit utilization rate indicates how much of your credit limit you're using at any given time, and using more than 30% can make you look riskier to lenders and drive down your credit score. If you get in over your head financially and use up a large amount of your available credit—or worse, hit your limit and max out—you can wreak havoc on your credit score.
How to Reduce the Risks of Borrowing Money
Now you know how certain borrowing decisions can harm your credit and endanger your financial well-being. Here's the good news: You can take measures to safely borrow money and avoid these pitfalls, and they can even help improve your credit in the process.
- Check your budget before you borrow. Before you take out a secured or unsecured loan, carefully review the estimated monthly payments and make sure they fit neatly within your budget to help you avoid becoming overextended.
- Avoid impulse spending. Credit cards make impulse shopping all too easy, so try to ensure what you put on the card is necessary and can be paid off immediately. This helps keep you accountable and avoid costly interest payments. Plus, keeping your credit card balance (and therefore your credit utilization rate) low can help improve your credit score.
- Pay your bills on time, every time. When you make on-time payments, you help strengthen your credit, avoid late fees and reduce chances of falling behind on your borrowing obligations. If you tend to forget to pay your bills, set up monthly calendar reminders or turn on autopay to make it a no-brainer.
- Consult the experts. If you're unsure whether you can safely afford a new loan or line of credit, it's better to get expert advice than guess and be wrong. Consider meeting with a financial advisor or credit counselor before you make any big moves to make sure you're not taking on more than your budget can reasonably handle.
Keep Tabs on Your Credit
Most forms of borrowing money will impact your credit, for better or for worse, depending on your financial habits. If you make responsible decisions, such as paying bills on time and keeping credit card balances low, your credit score is likely to improve over time. Monitoring your credit, which you can do for free with Experian, can help you track changes to your score and credit report, and notice how various factors impact your credit.