Credit scores are all about risk. They’re data-driven tools that take your history of using credit to determine how likely you are to default on (not pay) a future credit obligation like a credit card, personal loan, mortgage, and so on. So if you have a low credit score, you’re considered a high-risk borrower. But being a high-risk borrower doesn’t mean there aren’t loans for bad credit. If you have bad credit and are wondering how that might affect your ability to get a loan and how you can go about improving your credit, here are some things you need to know.
What Are High-Risk Loans?
“High risk loans” refer to the risk a lender takes when issuing credit to someone who has a history of making late payments, keeping credit card balances close to their limits, has recently applied for a lot of credit or has a very limited credit history. (You can see if you’re a high-risk borrower by reviewing your credit scores for free on Credit.com. You’ll get two scores updated every 14 days, plus personalized advice on how you can improve your credit so you are no longer considered a high-risk borrower.)
“A high-risk loan is a subprime loan that is offered to someone with a blemished credit history, according to their credit report,” said Thomas Nitzsche, media relations manager for Clearpoint Credit Counseling. He said these loans tend to carry double- or even triple-digit interest rates.
High interest rates are a way for lenders to justify loans to people with bad credit: If the borrower doesn’t repay the loan as agreed (as their low credit scores will indicate), the interest paid on that loan will at least reduce or make up for any losses.
What Are High-Risk Unsecured Personal Loans?
Again, high-risk loans refer to the risk that a lender takes on when working with someone who has bad credit. However, what sets these loans apart is the fact that they’re unsecured — that is, they do not require a guarantee, or any collateral that could provide security, such as a valuable possession, asset, property, car or home. Since the borrower does not have to put up any collateral, the loan is unsecured.
In order to balance the risk, these unsecured loans typically come with a high interest rate. If the borrower pays the loan as agreed, their credit will likely go up. But if they fail to make their payments on time or default, they could wind up in debt and damage their credit scores further. Many high-risk unsecured personal loans are available online and are easy to obtain. But it’s worth it to read the terms and paperwork closely so you know what you’re getting into.
Should I Use a High-Interest Loan to Pay Off My Credit Card Debt?
Consumers often look to personal loans as a way to consolidate their credit card debt and save money while paying it off. But that’s not always the right solution, especially you’re applying for a personal loan with bad credit.
Nitzsche said it’s extremely common for lenders to deny consolidation loan applications, as applicants tend to have a high debt-to-income ratio and low credit scores. If you do get approved for a personal loan despite your bad credit, the terms that come with high-risk loans may actually negate the benefits generally associated with consolidation loans.
For example, if the interest rate on your personal loan is higher than the average annual percentage rate (APR) across the credit cards you’re trying to pay off, you wouldn’t save money by consolidating your credit card debt.
Another benefit often associated with consolidating credit card debt by using a personal loan is that you’re given a firm structure for repaying the debt. Say the loan term is five years and has a fixed interest rate: You have to repay the loan within five years, and you’ll have the same loan payment every month. That specific timeline can be really helpful, given how long credit card debt can drag on if you’re only making minimum payments.
Still, you may have better options.
“For example, a creditor financial hardship plan can lower the interest rate and make the payment more affordable. Because credit cards report monthly payment history, sticking to these modified payment terms can also help improve credit,” Nitzsche said.
Another option is a debt management plan (DMP) through a nonprofit credit counselor, which can reduce your interest rates and consolidate all your monthly debt payments into one.
A DMP can negatively affect your credit because you generally have to close your accounts when you enter the plan and the plan will appear on your credit reports. (You’ll want to regularly review your free annual credit reports as you work to pay down debt and re-establish credit.)
At the same time, the plan can help you get in control of your debt and rebuild credit by making regular, on-time DMP payments. You can also work on rebuilding your credit with a secured credit card once you’re out of debt.
What Are Other Alternatives to High-Risk Loans?
If you can’t qualify for a consolidation loan with an interest rate lower than your credit card APRs, you may just want to focus on tackling the cards.
If you can no longer afford your credit cards’ minimum payments, that’s a different story.
“Consumers can consider settling their debt if it’s being handled by a collection agency,” Nitzsche said. “They can also consider seeking advice from a bankruptcy attorney to see if they qualify for Chapter 7 or 13. Another option can be to work with a local credit union or bank in a ‘second chance’ program, which usually includes some sort of financial education.”
Every solution has its pros and cons, so take the time to research your options and ask any questions about how they will affect your credit standing and overall financial health.
This article has been updated. It was originally published February 21, 2017.