In most cases, loans can be a useful tool to build credit. This is applicable only if the borrower pays back the loan on time. However, there are a few types of loans that can trap the borrower in an endless debt cycle. These are the loans to avoid. These types of loans are often advertised as useful, but they end up doing more harm than good. Payday loan Payday loans may sound attractive, but these are one of the common loans to avoid. To get a payday loan, a borrower writes a personal check to a lender. The check is for the loan amount along with the interest amount. In some cases, there can be a fixed amount for every $50 or $100 borrowed instead of the interest rate. Although these are small cash advances, the interest rates are often as high as 400 percent. The lender pays the loan amount on the check minus the interest or additional fees. However, the check is not cashed. The check is returned to the borrower when they repay the loan on the next payday. In case the borrower is unable to repay the complete loan amount, the loan is rolled over to the following payday. This is done after imposing a fee higher than the earlier fee. A rollover may seem like a benefit in the beginning. But most people tend to miss out on multiple payments, and the constant rollovers cause the loan to balloon up. This makes it more and more difficult to pay off the loan. A borrower gets trapped in an endless repayment cycle. 401(k) loans Another type of loans to avoid are 401(k) loans. 401(k) is often used to add to retirement savings. It is not possible to withdraw from a 401(k) account before the age of 59 years. In case early access is needed to the fund, one can borrow from the plan. However, this can be risky in the long-term. This is because taking finds from 401(k) account would be borrowing against one’s portfolio rather than saving toward it. Also, this will lower the total contributions made toward retirement. Furthermore, there is a double tax levied on 401(k) loans. This is because, when a loan is taken on this account, money is being borrowed from the principal as well as interest. This interest will have to be repaid into the 401(k) account with the income earned and taxed on. Later, another tax would be imposed when the funds are withdrawn after retirement. Tax refund anticipation loan These loans are taken to get tax refunds earlier than when the Internal Revenue Service (IRS) dispatches the money. A lender gives out the tax refund anticipation loan. This amount can be given out partially or in full. The amount is calculated based on how much the borrower is due to receive from the IRS. The anticipation loan is given in a couple of days. Ideally, once the refund from the IRS comes in, it is used to repay the anticipation loan. Despite this simplicity, tax refund anticipation loans are best avoided. This is because such loans often have very high interest rates and fee. It becomes quite difficult to cover the loan with just tax refunds. In case the tax refund amount is lesser than the loan amount, the borrower will have to pay the difference out-of-pocket. This additional expense is not tax deductible on the next return.
