Some people are fortunate enough to have the means to pay for everything they need in cash, without worrying about things like loans and repayment terms. For the rest of us, however, loans are an important part of financing major purchases and getting through expensive emergencies.
So, unless you’re one of the few who can get by without loans, your credit score is going to be a key part of your financial future. Unfortunately, it’s all too easy for a few credit mistakes to result in a low credit score, which can impact the quality of the loan terms you are offered — and determine whether you’re offered a loan at all.
A Low Score Means a Lower Chance of Approval
One of the earliest lessons most people learn when they have bad credit is that few lenders are willing to take the risk of lending to someone with a poor credit history. As a result, the first hurdle to getting a loan with decent terms for those with a low credit score is simply getting approved for a loan in the first place.
And this hurdle can be made even higher when you are in need of a large loan. While your income will have an impact on the size of the loan you can get, your credit score will also be a big factor. The lower your credit score, the less likely lenders are to offer you a loan of any significant size.
Most consumers have a few options for finding a loan with bad credit, including subprime lenders who specialize in financing consumers with poor credit. Lenders like these tend to have very flexible credit requirements that mean you won’t be rejected out of hand simply due to having a low credit score.
Another potential option for finding a lender when you have bad credit is your local credit union. While you’ll need to become a member of the credit union to take advantage of its services, it can be a great alternative to big banks with stricter lending requirements.
Your Loan’s APR Will Be Based on Your Credit Risk
Even if your low credit score doesn’t stop you from getting approved, it will directly impact other aspects of your loan offer, starting with your interest rate.
In essence, your APR will be based on your credit risk, which lenders determine by checking your credit reports and scores. If you have great credit, you are a low risk to the lender. In other words, the lender knows you have a good chance of paying back your entire loan because you have a proven history of paying back your debts.
If you have a low credit score, on the other hand, you represent a high credit risk. That’s because something in your credit history indicates you may be less likely to repay your loan. The typical big bank has a low risk tolerance, which is why the major banks tend to have fairly strict credit requirements; they don’t want to risk you defaulting on the loan.
Subprime lenders are generally banks with a higher risk tolerance; these lenders are willing to risk that you default on your loan because they can potentially reap big benefits through the higher interest rates they charge. Basically, every subprime borrower pays higher interest rates to make up for the large portion of other subprime borrowers who will default on their loans.
Bad-Credit Applicants May Be Charged Higher Fees & Deposits
A higher interest rate isn’t the only way loans get more expensive when you have a low credit score. Many subprime lenders will also likely charge higher loan fees, such as the origination fee, than regular big-bank prime lenders tend to charge. As with interest fees, these higher loan fees help make up for the higher risk presented by bad-credit applicants.
Additionally, the amount of money it takes to secure a loan will also typically be higher for borrowers with low credit scores. Traditionally secured loans, like auto loans, will often require a larger down payment or more valuable trade-in vehicle to help offset the increased risk to the lender.
If your credit is particularly poor, you may even be asked to provide a down payment or another form of collateral for a loan that is usually unsecured. Some personal loan lenders, for instance, may require that you use your vehicle or property as collateral to secure the loan before you can be approved.
A Qualified Cosigner Can Help Offset the Impacts of a Low Score
While having a low credit score can definitely make your loan more expensive, there is a way to potentially reduce the interest rates and fees you are charged for a loan: a cosigner.
Typically a friend or family member, a cosigner is someone with good credit who agrees to share financial responsibility for the loan. Basically, a cosigner agrees to repay the debt if the primary borrower can’t (or won’t) do so. This reduces the risk for the lender, and it may result in receiving better terms like a lower interest rate or reduced deposit requirement.