The biggest pros and cons of personal loans for bad credit
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Key takeaways
- A bad credit loan is a type of personal loan that caters to borrowers with credit scores below 670.
- If handled properly, bad credit loans can boost your credit score by adding to your credit mix and payment history, as well as consolidating credit card debt and improving your credit utilization ratio.
- On the downside, bad credit loans often carry higher fees and interest rates than other loans, as they are riskier for the lender. Some of these loans may also require collateral.
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, personal loans for bad credit come with higher interest rates and fees than other types of personal loans since they are riskier to the lender.
Before applying, consider the pros and cons of bad credit loans. Then 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 appeal if traditional lenders turn you away and you need cash for an emergency expense, home improvement project or big purchase.
Although bad credit loan interest rates and fees are higher than good credit loans, they offer 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 easier to get for borrowers with fair or poor credit.
The lender will likely consider other factors to make a lending decision. It may look for a consistent, verifiable source of income, your employment or your education history, for instance.
Could help you improve your credit
If you make on-time payments, a bad credit loan could help you boost your credit. 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, your credit utilization ratio may decrease if you use a bad credit loan to consolidate multiple credit card accounts. That could also help your credit score.
You may refinance to a personal loan with a lower rate if your credit score improves enough.
Lower rates than credit cards or payday loans
Bad credit loans come with higher interest rates than other types of personal loans. Rates may be similar to those of credit cards, which averaged 20.66 percent in May.
But credit card interest compounds daily. It adds up more quickly than a personal loan’s simple interest.
Additionally, the interest rate on most bad credit loans is capped at 36 percent in many cases. That is much lower than a payday loan, which usually has a triple-digit annual percentage rate (APR).
Bad credit loan drawbacks
Although personal loans for bad credit have their share of perks, there are downsides to consider when exploring your options.
High fees and interest rates
Lenders see a bad credit score as a warning sign you might fail to repay your loan. To balance that risk, they tend to charge bad-credit borrowers higher APRs and fees.
Some of these include origination fees, which can be as high as 12 percent of your loan amount, and prepayment penalties.
According to a Bankrate study, the average personal loan has a rate of 12.21 percent. Meanwhile, those with credit scores below 690 typically get 17.80 percent to 32.00 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. These “secured loans” offer more affordable rates than traditional unsecured personal loans.
But that’s because the collateral offsets the lender’s risk. If you default on your loan, the lender could seize the asset and sell it to repay your debt.
Increased predatory potential
It’s common for predatory products like payday loans to be advertised as bad credit loans. The primary difference between a legitimate and a predatory product is the interest rate, which may be 300 percent or more for a predatory one.
Another key difference is that predatory lending products tend to have much shorter repayment periods than traditional loans. Some are due within weeks after approval.
Though these loans typically don’t require a credit check, they can be very harmful to your credit and finances. The combined interest rate, fees and short repayment term can send you down an endless debt cycle if you can’t repay by your due date.
Shorter loan terms
Bad credit loans may come with shorter repayment periods than 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 personal loans for bad credit
Bad credit loans are risky for lenders, but they can also be problematic for your finances. Luckily, there are other options available, 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 designed specifically for borrowers with lower 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 in a certain field or living in a specific area or community, others only require a small deposit (usually $5) 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, loans for bad credit 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.
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