Loan choices are more limited when you have bad credit, but personal loans and other sources of financing are available. For anyone seeking a loan, it’s important to understand its terms so you can choose the best option with the lowest overall cost. If you have bad credit, this is especially important because, for the most part, the lower your credit score, the more expensive the loan will be.
“People do have options for loans if their credit isn’t good,” says Becky House, education and communications director for American Financial Solutions, a nonprofit credit and debt counselor. “But do the math. The loans will be more expensive.”
[Read: Best Bad Credit Loans.]
Who Decides a Credit Score Is ‘Bad’?
When you apply for a personal loan or any type of credit, lenders use your credit score to predict your risk as a borrower. Each lender has a different scale to determine what is considered good credit but may follow score ranges like this:
— Exceptional: 800 to 850
— Very good: 740 to 799
— Good: 670 to 739
— Fair: 580 to 669
— Poor: 300 to 579
Borrowers with higher scores are not only more likely to get approved for a loan, but they also tend to get better terms, like lower interest rates. Lenders may advertise their loans at a certain rate “on approved credit” or provide a wide range, for example “from 6.95% to 35.89%.” Borrowers with a high credit score may qualify for the 6.95% rate, while borrowers with bad credit may have to pay 35.89%. Someone with a low credit score is viewed as a higher risk, and lenders charge higher-risk customers more to offset the potential cost of default. Or a lender may opt to not approve a higher-risk customer at all.
What Are Your Bad Credit Loan Options?
“Traditionally, loan options for bad credit include using a co-signer, high interest rate credit cards or even payday loans,” House says. “Now we see a lot of new lenders and new products in the loan arena.”
The fees, rates, policies and overall quality of bad credit loans can vary widely, and some options are a poor choice for borrowers. It’s in your best interest to do your homework and resist the urge to respond to a sales pitch. House says a past client nearly took a $1,000 loan that would be repaid at $200 per month for three years — until a credit counselor pointed out that the total repayment would be $7,200. That means the annual interest rate on the loan was 240%.
Talk to your bank about special programs. “Some traditional banks and credit unions are willing to provide small-dollar loans to people facing hardships,” House says. Many banks and credit unions offer credit products to consumers with poor credit scores.
Consider nontraditional funding sources. Peer to peer, or P2P, lenders are different from traditional banks. A pool of investors, not a financial institution, funds each loan. An advantage is that the credit requirements tend to be more forgiving. A drawback is that these loans can be costly for applicants with weaker credit profiles, with interest rates even higher than credit cards.
Sidestep payday loans. Payday loans are notorious for extremely high fees. Interest rates are commonly 400% to 500% and are known to reach 1,000%. The fees are so high that paying off the loan can be difficult, and borrowers may pay more in fees than the original loan amount. Payday loans do not report to credit bureaus or help you build credit.
Avoid title loans. Vehicle title loans use your car as collateral against default. That means your car secures the loan, and if you don’t pay it, the lender could repossess your vehicle. Some title lenders require a GPS tracker so they can easily find and repossess your car if you default. Interest rates on these loans tend to be 300% to 400%. The inherent risk is that if you don’t repay the loan, you can lose your car.
Improve Your Chances of a Good Loan
If you need to borrow money but you’ve got a poor credit score, the goal is to find credit products that you qualify for at as low a cost as possible. You have a few options for planning your strategy.
Request an alternative credit score. One reason that a person can have a low credit score or no score is a lack of credit history. This is a common issue for consumers who pay their bills on time but maintain a cash lifestyle with no debt. But they have more options today to show their creditworthiness than ever before.
Various alternative credit-scoring models have been developed over the last few years: FICO Score XD considers alternative data sources, including cellphone, cable, internet and utility bills. The UltraFICO score, now in a limited pilot phase, factors in your banking relationships.
“Having some money set aside in a savings account is correlated with bill-paying behavior, even if your balance is only a few hundred dollars,” says Dave Shellenberger, vice president of product management for scores at FICO. He expects consumers to be able to opt-in to the UltraFICO score in late 2019.
[Read: Best Home Equity Loans.]
Get prequalified. Every time you apply for new credit, the inquiry is recorded in your credit file. This is called a hard inquiry, and each one could lower your score a bit — an undesirable result when your score is already low. If you apply for multiple credit products within a short span of time, you could make qualifying for new credit even harder. Also, some creditors automatically reject applications from people whose recent inquiries exceed a certain number. Fortunately, the effect of an inquiry on your score diminishes over the following 12 months.
Getting prequalified can help you preserve your credit score and reserve an inquiry for when you think you have a very good chance at approval. Before providing your information, verify that the prequalification application will not result in a hard inquiry on your credit report.
Boost your credit score. Building a great credit score takes time, but depending on why your score is low, a few actions can raise your score relatively quickly — and, in some cases, immediately.
— Check your credit reports for errors. Many consumers have credit report errors that can result in higher credit costs. No one will check your credit report for accuracy on your behalf. You can get a free copy every 12 months from each major credit bureau — Equifax, Experian and TransUnion — at AnnualCreditReport.com. You also have the right to dispute and request removal or correction of any data that you believe is incorrect. Most disputes are easy to initiate on the credit bureau’s website. If an erroneous item appears on more than one of your credit reports, dispute it with each bureau separately.
— Lower your revolving debt balances. If you can manage it, this one action could dramatically improve your credit score. “One of the fastest ways to improve your credit score is to pay off revolving debt,” says Shellenberger. Utilization is how much debt you carry relative to your credit limit. If you have a $400 balance on a credit card with a $500 credit limit, your utilization is 80%, which is much higher than the 30% or lower utilization rate most experts recommend. One way to lower your utilization ratio is to increase your credit limit, either by requesting an increase on an existing account or by opening a new credit card. But either of these could be difficult to do with a weak credit score.
— Time your payments. Do you have a credit card you use heavily but pay off every month? The balance may be reported when you have not yet made your full payment. Your credit score could reflect high utilization, even if you pay off your charges on time every month. Solve this by paying off your balance before it’s reported. Call your card issuer to find out the reporting date.
— Become an authorized user. When you become an authorized user on someone else’s credit card, his or her credit history affects yours. First, make sure the person handles the account responsibly, or this strategy won’t help you. You don’t have to use that person’s credit card, even if you’re on the account.
— Pay on time, every time. Your payment history influences your credit score more heavily than any other factor. Strive for perfection. Recent history is more important than older entries, so there’s no better time than the present to start improving your credit. Late payments stay on your credit report for up to seven years, but the older they are, the less they hurt your score. Also, extremely late payments hurt more than mildly late payments. In other words, a payment that is 30 days late will do less damage to your score than one that’s 90 days late or a collection account. If you have missed a payment, catch up as soon as possible.
— Leave old accounts open. Part of your credit score is based on the average age of all your accounts and the age of your oldest account. Unless there’s a reason, such as an annual fee you want to avoid, don’t close your oldest accounts.
What to Do if You’re Not Approved
If your loan application is denied, take a step back to reassess your needs and options. Remember, your credit score may go down a little after each application, so do not rush into multiple applications to see what you can get.
[Read: Best Debt Consolidation Loans.]
Depending on why you need the money, a secured loan, which is backed by collateral such as your home, car, savings account or investments, may be a good option. The credit score you need to get a cash-out refinance loan on your home, for example, may be lower than what you need for an unsecured personal loan. Some financial experts recommend that a loan secured by your home should only be used to maintain or improve the home itself. For example, if you need to fix a leaky roof, this may be a reasonable option to pursue.
If you need a personal loan to manage debt and your application for the loan is denied, talk to a credit counselor about starting a debt management plan, or DMP. A DMP is a formal agreement you enter with your creditors to address your outstanding debt. Your creditors may lower your interest rate or waive certain fees, but you will probably be required to stop using your credit cards.
The DMP is designed to repay all your debt within three to five years. You get an affordable monthly payment, and the collection calls stop. The National Foundation for Credit Counseling is a good place to find a certified credit counselor in your area.
House says that a risky time to look for a loan is when you’re desperate for cash. Borrowing can make your overall financial situation even worse. If you have a good relationship with your bank, talk to a loan officer there about your options, or perhaps ask a family member or friend for assistance. Be honest about your ability to pay loans back, and work on building a savings account to help cushion tough times over the long term. “Sometimes people think they need to have thousands of dollars in savings, but even a couple hundred dollars might help you cover a rent shortage or flat tire,” House says.
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