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 number that tries to define how risky you would be as a borrower.
Credit scores range from 300 to 850. 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 credit score is determined
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 because 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.
Ways to get a personal loan with bad credit
Knowing what to expect when you apply for a personal loan will help you prepare for the process. If you’re in the market for a personal loan and you have imperfect credit, here are eight steps to keep in mind.
1. Check your credit score and credit reports
Before you apply 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. Ensure that you can repay the loan
If you have bad credit, the last thing you want to do is take out a loan that you can’t repay. This will only make your credit score worse. As you shop for loans, make sure you know what the monthly payments will be and when they will be due. Consult your budget and monthly finances to make a plan for repayment.
If you will have trouble paying, consider other options for getting cash. You don’t want to take out a personal loan you can’t afford.
3. Compare bad credit loans
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 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.
4. Take advantage of prequalification
Prequalification, sometimes used interchangeably with pre-approval, allows you to find out if you will likely qualify for a loan. You can give the lender your information to find out if you are preapproved using a soft credit inquiry.
Why does this matter? Typically, a lending institution will do a hard credit check when you apply for a loan. A hard credit check can lower your credit score temporarily. This may be frustrating if you apply for a loan, get a hard credit check and are denied the loan. Then, you have to go apply for other loans with a possibly lower credit score than when you started.
Talk to potential lenders to see if you can get prequalified for a personal loan. Then, you can evaluate several loan options without multiple hard credit inquiries. Some lenders may even allow you to complete this process online in just a few minutes.
5. Look into secured loans
A secured loan is a loan backed by assets you have, such as a home or a car. Because secured loans use collateral to back your loan, they typically have better rates than unsecured loans. If you have collateral available to back your loan, this may be your best option with bad credit.
6. Add a co-signer if necessary
A co-signer is someone who agrees to sign on to the loan with you. They are agreeing to pay back the loan if you can’t. If you are having trouble qualifying for a loan, a co-signer can help you qualify if they have a better credit score and credit history.
Taking out a loan with a co-signer can make personal relationships go bad if you have trouble paying off the loan. Make sure you both know what you are signing up for if you decide to take out a loan with a co-signer.
7. Gather financial documents
When you apply for any type of loan, the lender will request several financial documents to complete your application. Gather these documents and pieces of information before you start applying for loans, as you may need some or all of them to complete your application:
- Personal contact info including social security number, full name, and address
- Your driver’s license or another form of personal identification
- Personal loan info such as why you need the loan and how long of a term you want
- W-2 forms for the last two years
- Your federal tax return for the last two years
- Two most recent bank statements for all bank accounts
- Recent pay stubs
- Utility bills or mortgage statement (to verify your address)
Your lender can always request additional documents, so be prepared to provide any extra requests quickly.
8. Be prepared for a hard credit check
When you are ready to officially apply for a personal loan, know that the lender will likely perform a hard credit check, also called a hard pull. In the short term, a hard pull will lower your credit score. Too many hard credit checks in a short time can make it look like you applying for loans that you can’t afford.
Be careful with how many loans you apply for and be prepared to see your credit score drop temporarily with a loan application. As you make timely payments on your loan, you should be able to get your credit score back up in a few months.
Types of bad credit loans
There are several types of loans that may be good for people with bad credit. A personal loan is not your only option. Consider these loan options as you shop around:
- Secured personal loan: A secured personal loan uses something you own as collateral, such as a house or a car. If you are unable to pay the loan, the lender has the right to take ownership of the possession you use as collateral for your loan. A secured personal loan typically comes with better rates and terms than an unsecured loan.
- Unsecured personal loan: An unsecured personal loan does not require any collateral from the borrower. Rates and terms aren’t as favorable as secured loans, but unsecured loans offer an option if you don’t have a possession you can use as collateral.
- Payday loan: A payday loan is a loan for a small amount that has a short-term repayment period — usually by your next paycheck. These loans typically have high interest and must be repaid in one lump sum payment. A payday loan is costly and most often isn’t the best option available.
- Cash advance: A cash advance on your credit card is a way to withdraw cash using your credit card. Most credit cards have limits on how much cash you can take out. It’s important to remember that you will be charged interest on any cash advance you take, and rates for cash advances are often higher than other credit card purchases.
- Bank agreement: If you have a relationship with your bank already, they may be willing to offer you a short-term loan agreement until you get your credit score back up. It never hurts to ask.
- Home equity loan: A home equity loan is a loan that allows you to access your home equity and use it as collateral for a loan. Your loan is disbursed in one lump sum and must be paid back in monthly payments.
- Home equity line of credit (HELOC): 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.
- Student loan: You can apply for both federal and private student loans. Both are options if you need money to pay for college. Federal student loans generally have better terms and rates than private student loans.
- Installment loan: 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.
- Peer-to-peer (P2P) loan: 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.
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.
How to improve your credit score
If you’re looking to improve your credit score, here are a few steps to get you started:
- Check your credit reports from the major credit bureaus. This will help you know where your credit is now and what you need to do.
- Make sure you’re making at least the minimum on all of your monthly payments.
- Make a written budget and make sure you are spending less than you make.
- Start paying down your debt using either the debt snowball or debt avalanche
- Look into using a credit boosting program like Experian Boost or UltraFICO.
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.