How to Protect Yourself From Loan Scams

The sophistication with which scammers pull the wool over people's eyes makes one wonder: What would have happened if they'd put their intellect to good use? How many discoveries might there be?

Of course, the question is moot. Scammers are folks who've decided they'd rather steal someone else's money than make their own. It doesn't matter if the person they're robbing is a construction worker or someone getting by on Social Security disability benefits. They want what's not theirs to take.

The best hope you (or anyone else) have of avoiding being scammed is to learn to recognize when it's happening. Here are some of the most common loan scams taking place today.

Image source: Getty Images.

No-credit-check-required scam

If you're ever offered a loan from a company claiming to be "reputable," make sure they plan to run a credit check. No legitimate company will give you a loan without checking your credit history, including your credit score. Companies are in the business of making money, and that isn't possible if they hand cash out to borrowers who can't pay it back with interest.

If a lender promises easy approval, it's likely because they plan to trap you in a predatory loan with a high interest rate, hidden fees, or both.

Red flag: Ads that feature phrases like "Bad credit welcome!" or "No credit? No problem" are aimed at individuals desperate enough to take the bait.

Advance-fee scam

With an advance-fee loan scam, a scammer promises to put you in contact with a lender who will approve your application. However, the scammer requires you to pay a fee first. They may call it an "application," "processing," or "administration" fee (or use some other name for the fraudulent charge). The moment you pay the fee, the scammer and your money disappear.

Red flag: Legitimate lenders don't need an upfront person to find borrowers for them. In fact, legitimate lenders have nothing to do with this scam.

Precomputed interest scam

While precomputed interest isn't illegal, it's the brainchild of lenders who want to squeeze as much money as possible from you. These are the kinds of people who don't care if the loan will eventually lead to you having your home or possessions foreclosed on. What they're interested in is making as much money off you as possible.

Here's what makes it so tricky: Not everyone is a math whiz, and it's easy to overlook the fine print when you genuinely need a loan. Even if you know and understand precomputed interest, it's easy to overlook the signs. Perhaps the best way to spot it is by comparing it to "normal" interest.

Normal interest: Calculated throughout the life of your loan and based on the outstanding balance. Let's say you borrow $10,000 with a five-year loan term and an 11% interest rate. At the beginning, you're charged 11% interest on the entire $10,000, but as the balance falls, you're charged interest on the new, lower amount.

You retire, and since part of your retirement plan is to retire with no outstanding debts, you decide to pay off the final $5,000. As long as your loan doesn't include a prepayment penalty, the lender doesn't receive a cent more in interest, even though you paid the loan off earlier than expected.

Precomputed interest: Rather than charging interest based on the loan's remaining balance, the entire loan's interest is calculated upfront and evenly spread across payments. Again, imagine that you borrow $10,000 with a five-year loan term and an 11% interest rate. Using precomputed interest, the lender calculates how much you'll repay over the life of the loan. In this case, you're borrowing $10,000, and the lender expects to receive an additional $3,045 in interest payments.

Precomputed interest allocates more of your payment to interest early in the loan, and making extra payments doesn't reduce the principal or interest you owe. This means you'll ultimately pay more in interest, even if you pay the loan off early.

Red flag: If you see the terms "Rule of 78" or "precomputed interest" anywhere on a loan contract, you know that the loan will be more expensive than necessary.

Insurance fee scam

If someone says that you "must" purchase insurance before you can be approved for a loan, they're trying to put extra money in their pocket. No personal loan requires insurance. Even if you're buying a vehicle (which is not a personal loan, but a secured loan), the lender doesn't get to say who you purchase insurance from. That's between you and your insurance company.

Red flag: A salesperson insists that you must purchase an insurance policy on the loan you're applying for. It's simply not true.

How to protect yourself

You can protect yourself from loan scams by taking the following steps:

• Research the lender: Verify the lender is licensed to do business in your state and has a good reputation. Check for online reviews. If you have any doubt, walk away.
• Never pay an upfront fee: No legitimate lender requires an advance fee.
• Read the fine print: Carefully review the loan terms to ensure you fully understand what you're signing up for.
• Ask someone you trust for their advice: Whether it's a relative, friend, banker, financial advisor, or other trusted individual, get someone else's opinion.

From paying off your student loans to planning for college for your kids, every dollar matters. Don't let someone unwilling to earn money the legitimate way get their hands on your hard-earned cash.

The Motley Fool has a disclosure policy.