Pros and cons of bad credit loans

Bad credit loans are a type of personal loan designed specifically for consumers with lower credit scores — typically under 670. These loans make credit more accessible to borrowers who likely have trouble finding personal loans elsewhere. Still, bad credit loans come with higher interest rates and fees than other types of personal loans since they are riskier to the lender.

Before applying for a bad credit loan, consider the benefits and drawbacks to decide if it’s a good fit or if you’re better off considering an alternative funding option.

Bad credit loan benefits

Bad credit loans may seem attractive if you’re tight on cash and need to pay for an emergency expense, finance a home improvement project or a big purchase and most traditional lenders have turned you away. Although these loans do come with higher interest rates and fees than good credit loans, they come with some advantages.

More flexible lending guidelines

Personal loans from traditional banks and credit unions usually require good or excellent credit. But, as the name suggests, a bad credit loan is accessible to borrowers with fair or poor credit. The lender will likely consider other factors — consistent, verifiable source of income, your employment or education history — to make a lending decision.

Could help you improve your credit

If you make on-time payments, a bad credit loan could help you boost your credit since payment history accounts for 35 percent of your FICO score. Adding a personal loan to your portfolio could also improve your credit mix, which accounts for 10 percent of your FICO score. Additionally, if you use a bad credit loan to consolidate multiple credit card accounts, you could see your credit utilization ratio decrease, which could also impact your credit positively.

Lower rates than credit cards or payday loans

While bad credit loans come with higher interest rates than other types of personal loans, they may carry lower rates than most credit cards, saving you a lot of money on interest in the long run. Additionally, the interest rate on most bad credit loans is capped at 36 percent — much lower than a payday loan, which usually have triple-digit interest rates and fees.

Bad credit loan drawbacks

Although bad credit loans have their share of perks, there are downsides to consider when exploring your options.

High fees and interest rates

Because bad credit lenders take on a higher risk, they tend to add higher fees than those charged by traditional institutions, such as banks and credit unions. This, in turn, could translate to steeper borrowing costs. Some of these include origination fees, which can be as high as 12 percent of your loan amount and prepayment penalties.

Interest rates for personal loans currently go from about 6 percent to 36 percent. However, the lowest rates are generally reserved for borrowers with very good or excellent credit. For instance, according to a Bankrate study, the average personal loan has a rate just above 11.5 percent. Meanwhile, those with credit scores below 670 typically get rates of roughly 18 percent to 32 percent.

Negative credit impact

If you take out a bad credit loan and the monthly payment stretches your budget too thin, you’re more likely to fall behind on the loan payments. If the loan becomes 30 or more days past due, the lender may report the delinquency to the credit bureaus.

This negative mark could drag down your score for up to seven years, impacting your ability to get approved for other credit products.

Collateral requirements

Some bad credit loans require collateral to approve you for the funds. This type of loan, known as a secured loan, offers more affordable rates than traditional unsecured personal loans since it’s less risky for the lender. But, if you default on your loan, the lender could seize the asset you used as collateral to insure your payments.

Increased predatory potential

It’s common for predatory products and loans to be advertised as bad credit loans. The primary difference between a legit and a predatory product is the interest rate — a predatory product may have an interest rate of 150 percent or more. Another key difference is that predatory lending products tend to have much shorter repayment periods than traditional loans — some due within weeks after approval.

Though these loans typically don’t require a credit check, they can be very harmful for your credit and finances since the combination of exorbitant interest rates and fees along with a short repayment term can send you down an endless debt cycle, if you aren’t able to repay by your due date.

Shorter loan terms

It’s not uncommon for bad credit loans to come with shorter repayment periods compared to traditional loans. A shorter repayment term means you’ll pay less interest than you would with a longer term, but it’s not without a downside.

The monthly payment is affected by the loan term. Because of this, the payment could be much higher than you can comfortably afford if you are taking out a larger amount.

Alternatives to a bad credit personal loan

Bad credit loans are risky for lenders, but they can also be problematic for your finances. Luckily, there are other options available at your disposal, including the following:

• Borrow from a friend or relative: Ask a trusted friend or relative for a loan to get you over the hump. If they agree, come up with payment terms and create a written agreement.
• Use a new or existing credit card: If you already have a credit card, you can use it instead of taking out a bad credit personal loan. Likewise, some companies offer unsecured credit cards are designed specifically for borrowers with less-than-perfect credit. Most come with high interest rates and fees but can be more cost-efficient than a bad credit personal loan. That said, pay the balance off as soon as possible to minimize interest charges.
• Consider getting a loan through a credit union: Credit unions tend to be more lenient with their requirements than banks and other lenders. Although some of these restrict memberships to those working ion a certain field or living in a specific area or community, others only require a small donation (usually $5) to one of their partner nonprofits to join.

The bottom line

When deciding if a bad credit loan is right for you, consider its impact on your finances. A lower credit score means you’ll pay more in interest and have a higher monthly payment. Depending on the repayment period you receive, you could spend a fortune on interest unless you can pay the loan off early.

Still, a bad credit loan could be ideal if you find a product with fair terms and an affordable monthly payment. It can help put your finances back on track and enable you to build your credit score so you can qualify for better loan offers in the future should the need arise.

If you decide to use a bad credit loan to get fast cash, shop around and compare loan offers to find the best deal. Many lenders let you get prequalified online in minutes without affecting your credit score, making it easier to choose the best option for you.