Consumers with bad credit (credit scores under 620) have a difficult time borrowing. Interest rates are high, and financing is hard to come by. For those without assets to put up as collateral for a loan (such as a car that can be repossessed if they don't pay up), it's even tougher. Yes, there are advertisements for unsecured personal loans for people with bad credit.
But are there actual loans available to real people?
Personal Loans for Bad Credit: Why It's Hard to Find
Unsecured loans for bad credit are hard to find because the default rate is very high. Personal loan lenders' profit depends on managing the expected default rates associated with different groups of loan applicants. This chart from the FDIC shows expected default calculations for a group of unsecured borrowers. They divide the number of non-defaulters by the number of defaulters to come up with the odds of default for each FICO group.
From this, it's apparent that borrowers with FICOs under 600 default at approximately a 50 percent rate (for every hundred borrowers, 50 default, so according to the FDIC formula, 50/50 = 1.0), while those with scores of 700 default at approximately a five percent rate (95/5 = 20).
Obviously, for a lender to make the same amount from a group that defaults at a 50 percent rate as it would from a group which pays as agreed 95 percent of the time, the interest rate must be higher. Here's how that might work:
- Lender wants a 5.0 percent return, so for every $1,000 loaned, it needs to get back $1,050.
- Prime borrowers repay 95 percent of the time, so for every $1,000 loaned, $950 is repaid.
- The interest rate needed to get $1,050 back from the $950 is 11 percent.
See how this changes when the default rate hits 50 percent.
- The lender still wants $1,050 back for every $1,000 loaned.
- Half of Grade F borrowers default, so for every $1,000 loaned, only $500 is repaid.
- The interest rate required to return $1,050 from $500 is 110 percent!
That's why for people with poor credit scores, finding a personal loan is difficult-- lenders either can't or don't wish to charge such high rates, and they do want to stay in business.
Finding a Bad Credit Personal Loan
Start with your bank or other financial institution
If you have a checking or savings account, your bank may be more willing to approve a personal loan. If you can get a small personal loan and pay it off on or before its due date, this can help you improve your credit and qualify you to borrow larger amounts.
Get a cosigner
Asking a family member or close friend to cosign a personal loan can put your relationship at risk if you fail to repay your loan, but it may be the only alternative if you need cash in a crunch. Before asking someone to cosign a personal loan contract, be very sure that you can repay the loan according to the lender's terms. Late or missed payments will cause the lender to contact your cosigner. If your cosigner makes payments on your loan to save his or her credit, you can expect problems with your relationship. One huge advantage of using a cosigner, though, is that the interest rate will be much better assuming the cosigner's credit is good or excellent.
Ask about a secured personal loan
You may be able to use your car as collateral for a personal loan. Not to be confused with costly short term auto title loans, a secured personal loan can provide lower interest rates and the opportunity to demonstrate your creditworthiness. Once you've repaid your secured personal loan, the lender will remove its name from your car title. Secured personal loans may not be an option if you're making payments on your car.
Watch Out for Expensive Short Term Loans
You've heard about how easy it is to use your car title or pawn valuable items for cash. While these options may work in an emergency, the Federal Trade Commission advises they are very expensive and that you may find it impossible to repay such loans before your collateral is taken by the lender. In many cases, borrowing high cost loans when you're desperate only makes your financial situation worse. It may be worthwhile to swallow your pride and ask for help from a friend or family member before opting for a cash advance or payday loan.
In some cases, you may not qualify to borrow a personal loan if you have bad credit.
If your bad credit was caused by impulsive shopping or other money management mistakes, contacting a credit counseling service to fix your financial problems may be your best choice before borrowing more money. HUD approved housing and credit counseling agencies can help you establish a cash-based budget according to your income and obligations. If you can afford to repay your creditors, credit counselors can work with your creditors to develop affordable repayment arrangements. While credit counseling services typically require you to close active credit card accounts, their debt management programs can provide a fresh start without the problems associated with filing bankruptcy.