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 — like a 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. Besides that, the interest rate on most bad credit loans is capped at 36 percent — that’s also much lower than recurring to 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, as mentioned above, there are downsides to consider when exploring your options.

High fees

Because bad credit lenders are taking 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 fees include origination fees, which can be as high as 10 percent of your loan amount and prepayment penalties.

High interest rates

Interest rates for personal loans currently go from about 5 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 of 11.29 percent, meanwhile those with credit scores below 670, typically get rates of roughly 18 percent to 32 percent.

Collateral requirements

Some bad credit loans require collateral to approve you for the funds. This type of loan, known as a secured loan, does offer more affordable rates than traditional unsecured personal loans. 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.

How to tell if a bad credit loan is right for you

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 a higher monthly payment. Depending on the repayment period you receive, you could spend a fortune on interest unless you’re able to 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.

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.

• Existing credit card: If you have a credit card with available credit, you can use it instead of taking out a bad credit personal loan. That said, be sure to pay the balance off as soon as you can to minimize interest charges.
• Request a higher balance: Similarly, you can request a higher balance from your credit card company. You can use the extra funds for any cost, and once you pay it back, you’ll reduce your credit utilization ratio — improving your credit score.
• 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.
• New credit card: Some unsecured credit cards are designed 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.
• Sign up for alternative credit data: You may be able to include rent payments or regular bills in your credit score with a service like Experian Boost. This will improve your score by counting the hard work you already do to manage your budget.

The bottom line

Personal loans are harder to get when you have bad credit. 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.