If you’ve been late paying your bills in the past or have a mountain of debt, your credit score may be lower than you’d like it to be. Bad credit can be a frustrating disadvantage, particularly when it comes to getting lenders to trust in your ability to pay them back over time.
If an emergency expense crops up or you want to consolidate your debt, a personal loan can be a good option. However, it’s important to keep in mind that obtaining a personal loan with an inferior credit score will likely mean that you’ll end up paying higher interest rates and fees.
How bad credit scores affect borrowing
Your credit score represents your creditworthiness, so having a particularly low score will have a variety of ramifications on your personal loan application, including the interest rate and terms you may be offered.
“Lenders seek to mitigate their risk by charging a higher interest rate so that the majority of the money that’s borrowed is recouped via fees as opposed to worrying about whether the individual will pay the loan back or not,” explains Ash Exantus, director of financial education for BankMobile.
Your credit score may also impact the total loan amount lenders are willing to provide. And in some cases, lenders may opt not to offer a loan at all because of the risks associated with a borrower who has a history of making late payments, defaulting on financial obligations or having accounts in collection.
“Poor borrowing habits depreciate one’s credit, making it harder to get a future loan,” says Steve Sexton, CEO of Sexton Advisory Group.
Getting a personal loan with bad credit
If you’re in the market for a personal loan and you have imperfect credit, here are three steps to keep in mind.
1. Check your credit score and credit reports
Before you begin applying for a personal loan, take a close look at your credit report and credit score, says Bruce McClary, spokesman for the National Foundation for Credit Counseling.
Those two things play a major role in the interest rate you’ll pay. Use your credit score and Bankrate’s loan prequalification tool to determine what rates you’re likely to qualify for.
Federal law entitles you to a free copy of your credit report every 12 months from the major credit-reporting bureaus: Equifax, Experian and TransUnion. With your report in hand, you’ll know exactly what your credit score is, and you’ll be able to identify any black marks on your record. If you find errors on your report, you can try to correct them before applying for a bad-credit personal loan.
2. Shop around
While a bad credit score will not qualify you for the best rates and terms, don’t assume that only the worst rates and terms will be available. You may get a better deal at your bank or credit union.
If you have a relationship with a community bank or credit union, it can be to your advantage. If the bank knows you and your spending habits, your low credit score can be mitigated by your history of paying on time and keeping a balance in your accounts.
There are also a number of reputable online lenders that offer loans to consumers with poor to average credit scores. Some of Bankrate’s recommended bad-credit personal loan lenders offer rates starting as low as 4.99 percent.
3. Do your homework
When you find a lending institution that looks promising, be sure to spend some time researching its background to ensure that it’s not a scam.
Check to see if any complaints have been made with your state attorney general’s office or the federal Consumer Financial Protection Bureau.
Also, find out the maximum interest rates allowed by law in your state and whether your prospective lender is licensed to conduct business there.
You should also avoid loans that seem too good to be true or too easy to acquire, such as payday loans or car title loans. If you have bad credit, these kinds of loans can be tempting, but they often include exorbitant interest rates (as high as 500 percent) and can leave you in a difficult financial situation.
Bad-credit loan considerations
While it’s always important to weigh the various costs and risks associated with a personal loan, there are a few additional things to keep in mind for bad-credit loans.
A loan costs more with a low credit score
The unfortunate reality of applying for a loan with a less-than-ideal credit score is that you will be paying more than someone who has a higher credit score.
“Banks and lenders typically assess your credit score by tapping providers like FICO or VantageScore. These providers use credit scoring models like loan balances, payment histories to determine your credit worthiness. The lower the score, the harder it is to borrow money,” explains Sexton. “If you have a lower score and do qualify for a loan, you will likely pay a higher interest rate to make up for the default risk.”
Keep an eye out for predatory lenders
Individuals who have a poor credit score may also be targets of aggressive direct mail campaigns that market personal loans with low interest rates of around 6 percent or 8 percent.
However, these campaigns frequently advertise an introductory or “teaser” rate that will increase after the limited-time offer expires; if you don’t have a plan for a rapid payoff, the rates can skyrocket to the 20 percent to 30 percent range, which is likely much higher than the rate you can qualify for with a reputable lender.
Read the fine print
Because those with bad credit scores are considered a higher risk, which often translates into higher costs of borrowing, be sure you’re clear on exactly what you’ll be paying to get the loan. When signing on for a bad-credit loan, read the loan agreement and fully understand how your interest will be charged and structured.
“Many loans are advertised with a nominal interest rate, but don’t clarify that it is a monthly interest rate, not an annual one, until the paperwork phase,” says Sexton.
In addition, beware of any add-on loan costs. Again, this goes back to reading the agreement closely and in full to make sure there aren’t any fees or add-on services your loan officer may have glossed over.
“You should be cognizant of the interest and fees associated with the loan,” says James Lambridis, CEO of DebtMD. “Many times, a bad credit loan comes with higher origination fees or closing costs than usual.”
Improve your credit health
It’s worth noting that if you’re not in a hurry to obtain the money, it can ultimately make more sense to spend time trying to improve your credit score rather than proceed with an extremely high-interest loan. A few areas to focus on if you’re looking to improve your credit picture are:
- Payment history. The most vital factor in measuring your credit score is payment history; in fact, payment history accounts for 35 percent of your FICO score. Your score takes a hit if you have a pattern of missing or late credit card payments (known as delinquency). Payment history also incorporates the on-time payment of other debt sources, such as car and mortgage loans.
- Credit utilization. This is a ratio of how much available credit you have versus how much you’re currently using. It accounts for 30 percent of your FICO score. If you hold a credit card with a $5,000 limit, for instance, and you have a $250 balance on it, your credit utilization ratio would be 5 percent. If you have multiple cards or loans, your ratio is measured across all of these debt sources. A higher ratio typically signals to lenders that offering you a loan may be risky, since you may have trouble making on-time payments.
- Length of credit history. In general, the longer you’ve been building credit, the more beneficial it is for your score. A longer history of borrowing and making payments on time gives lenders confidence that you will repay your debts within the specified time frame. While it’s less important than your payment history, length of credit history accounts for 15 percent of your score and takes priority over other factors like credit mix.
- Types of credit. Your score will incorporate how many different forms of credit you’ve used, including credit cards and loans — also known as your credit mix. The more diverse your mix (assuming you’ve been making payments on time), the more beneficial it is to your score. While it’s not the most critical factor in calculating your score (it represents 10 percent of your total), it’s a relatively easy one to manage and improve.
- New credit. The final 10 percent of your score is determined by the amount of new credit on your account. Try to pace yourself when opening new accounts, especially if you don’t have a long credit history. Applying for too many cards or loans within a short time frame can be detrimental to your score. It also evaluates how many credit inquiries you’ve initiated in the past 12 months. Inquiries occur when you’re shopping for a new loan or card and the lender pulls your credit report.
The bottom line
Knowing your credit score can give you an idea of the rates you can expect and how much you will be paying each month on your personal loan. Online lenders and banks are great options for finding the right loan, but check out the brick-and-mortar banks and credit unions, too. Use watchdog agency reports to help you make sure that you are getting a loan from a reputable company and not a predatory lender.
Featured image by Viktoriia Hnatiuk of Shutterstock.