Pros and Cons of Bad Credit Personal Loans

Some lenders offer personal loans specifically for borrowers with bad credit. They can have better rates than other types of bad credit loans, like payday loans, but be easier to qualify for than loans for good credit. But they can also have drawbacks, like shorter repayment terms, fees, and/or high interest rates. You might even need to use an asset as collateral to get approved.

Weighing the pros and cons of a bad credit personal loan is a must before applying, especially if you're proactively trying to improve your credit score. Learn how a personal loan could help or hinder that process and explore a few alternatives to get the money you need.

Advantages of bad credit personal loans

Bad credit personal loans have some perks, like having easier-to-meet requirements than other types of loans and the potential to boost your credit.

Less stringent lending standards

While not all lenders extend loans to borrowers with bad credit, those that do tend to make it easier for borrowers to get approved by considering factors beyond a credit score.

"At America First Credit Union, decisions are not necessarily based upon good or bad credit," but on creditworthiness factors, says Jennifer Jessop, Debt Solutions Manager at America First Credit Union. "Some of the factors include the number and length of established tradelines, a consistent payment history reflecting the ability to pay, length of time on a job and proof of income, and debt-to-income ratio."

Learn More: Debt-to-Income Ratio: What To Know 

So, if you've had a steady income from the same job for several years and your income is sufficient to support your current debts plus a new personal loan, some lenders might approve your loan despite having less-than-ideal credit.

Compare personal loans for bad credit

May help improve your credit

Your payment history makes up 35% of your FICO score. When you make payments to a personal loan on time each month, you could see your score gradually increase.

A personal loan can also decrease your credit utilization if you use it to pay off credit card debt or lines of credit. Credit utilization is the amount of available credit you use on revolving debt like credit cards. Your credit utilization ratio is one factor affecting the amounts owed category of your FICO score, which accounts for 30% of your overall score.

If you consolidate revolving debts with an installment loan, like a personal loan, you'll pay off your balances and lower your credit utilization. This could improve your score within one month since credit cards typically report your balance to the credit bureaus every month.

Better rates than payday loans or credit cards

Personal loans have much lower APRs than other types of bad credit loans. Consider payday loans, for example, which can have APRs over 600% in some states, and car title loans, which sometimes have APRs of over 300%.

The rate difference between bad credit personal loans isn't as stark, but is still important. For instance, unsecured credit cards for bad credit can carry APRs around 36%. Take the Avant credit card, for example, which has a 35.99% APR plus an annual membership fee. Rates on personal loans for bad credit also tend to be above 30%, but average around 32% to 33%, according to Credible data, depending on the repayment term.

For the lowest interest rates, consider a secured loan, which uses collateral you own to reduce the lender's risk in lending money to you. These often have lower APRs than an unsecured loan and may have easier qualification requirements. However, pledging an asset such as a home or a car as collateral on a secured loan could put the asset at risk of foreclosure or repossession if you default.

Compare: Personal Loan vs. Credit Card

Disadvantages of bad credit personal loans

Even if a bad credit loan seems like a good idea right now, it might not be in the long term. Here's what to consider.

Costly fees and interest rates

Many personal loan lenders charge as much as 36% APR for borrowers with bad credit. If that's your best-case scenario, here's how it would look for a few different loan balances:

So, for a $10,000 loan with a five-year repayment term, you'd pay more in interest than your loan amount.

Fees can add to your loan costs. Late fees are common when you miss a payment, although many lenders have a grace period of 10 to 15 days to give you a little more time to pay before assessing a fee.

Origination fees are also common, especially on bad credit personal loans. A lender charges this fee upfront, which could be as much as 12% of your loan amount, depending on the lender. The origination fee typically comes out of your loan before funding, so you'll receive less. For example, a 3% fee on a $3,000 loan is $90, so you would get $2,910. Fortunately, origination fee are accounted for in the loan's APR, which is helpful when comparing loans with origination fees to loans without.

Can hurt your credit

When you apply for a personal loan, your score might decrease by a few points because of a lender's hard credit check. This is only temporary — hard inquiries affect your credit score for up to one year and stay on your credit report for up to two years.

Mismanaging a loan can have bigger consequences. Payment history makes up 35% of your FICO score. Getting a larger loan than you can afford could make it difficult to make your monthly payments on time and hurt your credit.

And while consolidating debt with a personal loan could help you lower credit utilization, you'll need to be careful about how you handle the new loan and other credit lines. "If you don't trust yourself to pay down high-interest debt with a personal loan and stop racking up debt, then it's not a good idea to apply for one," says Lillian Turner, a certified financial planner and founder of Daring Greatly Wealth, LLC.

"Tackling the behavior that underlies your overspending is really important before you decide to go for a solution like getting a personal loan."

May require collateral

If your credit prevents you from getting an unsecured loan, your lender might suggest using collateral to apply for a secured loan. If you don't have an asset of value or a type of asset the lender accepts, a secured loan won't be an option. But if you do, collateral could help you qualify, although it comes with risks.

"Putting up collateral can be like playing with fire," says Turner. "Not only are you risking your credit score tanking" if you can't make your payments, "but you are also risking the asset that you put up for collateral."

Check Out: What Can Be Used As Collateral for a Personal Loan?

Shorter repayment terms

Lenders see borrowers with bad credit as riskier because there's a higher chance of them not repaying a loan. To reduce this risk, lenders might offer only shorter repayment terms, like one, two, or three years, to pay off a loan.

Paying off a loan in a shorter period can reduce the amount of interest you pay. For example, a $3,000 loan with a 36% interest rate and a two-year term would cost $1,251 in interest. Shortening the term to one year lowers interest to $617.

However, shorter terms mean higher monthly payments. Using the same example, the two-year loan would have a monthly payment of $177, compared to the one-year loan's payment of $301 per month.

Check Out: How To Compare Personal Loans

How to get a personal loan with bad credit

Here's what to do to apply for a bad credit personal loan:

1. Review your finances: Make sure you can comfortably afford to pay for a loan to avoid damaging your credit further. Calculate all your monthly bills and subtract the total from your monthly income to find what's left over and how much you can reasonably pay for a loan.
2. Check your credit: Know your credit score so you can find a lender that may work with you. Your bank or credit card company may offer free credit score monitoring; also, use AnnualCreditReport.com to see your credit report for free.
3. Compare lenders: Spend time researching lenders with bad credit personal loans. Check their APRs, repayment terms, and fees to find the best fit.
4. Prequalify with multiple lenders: See what you might qualify for by prequalifying with multiple lenders. This process lets you check potential rates and terms without harming your credit. You may see a temporary dip in your score only after you apply for a loan.
5. Gather documents and apply: Have identification, like a driver's license, and proof of income ready when you apply for a loan. If approved, your lender sends you a final offer to review and sign.
6. Receive funds: Expect your loan funds to arrive in your bank account within a few business days, although some lenders fund loans the same day or next day after applying.

Related: How To Get a Personal Loan

Alternatives to personal loans for bad credit

If you've considered the pros and cons of bad credit loans and aren't sure if you should get one, here are a few alternatives that could be better options.

401(k) loan

A 401(k) loan is taken out against your 401(k) balance. They don't require a credit check because the amount you borrow is based on your retirement account balance (it's your money). That's good news if you have had difficulty qualifying for a personal loan due to your credit. However, whatever you borrow won't earn interest until you pay it back.

Another point to consider: You're limited as to how much you can borrow. Currently, the IRS allows you to borrow the lesser of 50% of your balance or $50,000, or up to $10,000 if 50% of your vested balance is lower than $10,000.

Compare: 401(k) Loan vs. Personal Loan

Borrow and save loan

A borrow-and-save loan lets you borrow money and put that money into a locked savings account. Say, for example, you request a loan for $2,000. The lender may give you a 50% loan advance, or $1,000, in cash and deposit the other $1,000 into a locked savings account so you can start building your savings fund. You then receive the remainder once you're done paying off the loan.

You'll usually find these loans through credit unions, although they're less common than other types of loans. Since you don't get all the money upfront, these loans can have much lower APRs than other bad credit loan types, such as 18% for a 12- or 18-month loan.

Share secured loan

A share secured loan is backed by your savings account balance, so you usually won't need a credit check to get one. You also get to keep the money you have in your account so it can continue to grow interest, but that money will be unavailable for you to use until you repay the loan.

New income sources

Boosting your income can also be a viable alternative instead of borrowing the money you need, especially if you don't need a large loan. "If you can't (at least temporarily) cut back on some expenses," says Turner, "I would suggest finding a side hustle to bring in extra money." For example, rideshare driving, pet sitting, selling artwork, or helping neighbors with home repairs or landscaping could give you additional income to work with.

Alternatively, consider asking for a paycheck advance from your company if you need emergency cash. Or, for a more long-term solution, you could ask your boss for a raise.

Read More: 

• Ways To Improve Your Personal Loan Application
• What Is a Bad Credit Personal Loan?
• Types of Bad Credit Loans
• Where Can I Get a Bad Credit Loan?
• How To Get a Personal Loan With a 500 Credit Score
• How To Get a Personal Loan With a 550 Credit Score
• Best Personal Loans for Bad Credit