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.
A personal loan can be a good way to pay for emergency expenses or consolidate debt. While having an inferior credit score will mean paying higher interest rates, it’s still possible to obtain a personal loan with bad credit by taking some simple steps to improve your score and shopping around with multiple lenders.
What does it mean to have bad credit?
Almost every American has a credit file compiled by one or more of the three credit bureaus: TransUnion, Equifax and Experian. Your credit files are used to compile a credit score, which is a single number that tries to define how risky you would be as a borrower.
Credit scores range from 300 to 850, and generally anything under 580 is considered “bad.” If you have bad credit, you typically have a short credit history, a history of late payments, lots of debt relative to your income or any combination of those factors.
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 amount lenders are willing to lend you. And in some cases, lenders may opt to not 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 collections.
Ways to get 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.
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 negative marks on your record. If you find errors or old debt on your report, you can try to correct them before applying for a 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 5.67 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.
If it’s not a lender you recognize, 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.
Types of bad-credit loans
There are several different types of loans that may be good for people with bad credit — a personal loan is not your only option.
An installment loan — an umbrella term that includes personal loans — is a type of loan that lets you borrow a specific amount of money and pay it off over time. Unlike a credit card, where you have access to a revolving credit line and are charged interest based on the amount that you use, an installment loan gives you a lump sum upfront. You’ll then pay a fixed amount for a specified number of months.
A home equity line of credit (HELOC) is another type of loan that you might be able to get if you have bad credit. A HELOC will only be an option if the mortgage balance on your primary residence is significantly less than your home is worth. As the name implies, a HELOC is a revolving line of credit analogous to a credit card. You will have a limit based on the amount of equity you have in your home, and you’ll be charged interest only on the purchases you actually make on the line.
Peer-to-peer lending is another alternative to a traditional loan that may be an option for someone with bad credit. Most peer-to-peer lending takes place with online personal loan lenders, like Prosper or LendingClub. With peer-to-peer lending, you’ll apply for a loan as usual, but the loan is funded by individual investors rather than by the lender itself.
You should 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), leaving 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 and payment histories to determine your creditworthiness. The lower the score, the harder it is to borrow money,” explains Steve Sexton, CEO of Sexton Advisory Group. “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.”
Predatory lenders prey on people with low credit scores
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.
Add-on costs may be hidden in the fine print
Because those with bad credit scores are considered a higher risk, be sure you’re clear on exactly what you’ll be paying to get the loan. When applying 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.
There are ways to improve your credit score
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 (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 (30 percent of your FICO score). This is a ratio of how much available credit you have versus how much you’re currently using. 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 (15 percent of your FICO score). 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.
- Types of credit (10 percent of your FICO score). 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.
- New credit (10 percent of your FICO score). Your score takes into account the amount of new credit on your account and how many credit inquiries you’ve initiated in the past 12 months. Try to pace yourself when opening new accounts or applying for new loans, 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.
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.