Bad credit loans: 5 risks to be aware of before getting one

Allison Martin

Key takeaways

  • Loans for bad credit often come with high rates and fees.

  • Watch out for lenders that contact you consistently, promise approval or charge rates above 35.99 percent, they're likely a scam.

  • There are lenders that base eligibility on factors other than just creditworthiness.

A bad credit score is classified as a FICO score of 669 and under, or a VantageScore below 661. Although you may have a hard time qualifying for a personal loan with a bad credit score, some lenders may still approve you for a loan. However, bad credit loans usually come with steep interest rates, fees, shorter loan terms and other drawbacks that are worth considering before you take the plunge.

Risks of taking out a bad credit loan

Bad credit loans are a convenient solution to access fast cash if you can’t get approved elsewhere. Still, they come with drawbacks to keep in mind before applying.

1. Higher interest rates and fees

Lenders evaluate your credit score to determine the likelihood of default on a personal loan. Consequently, a lower credit score generally means a higher interest fee and origination fees to help minimize risk.

The average interest rate for borrowers with bad credit is between 28.5 percent and 32 percent, but some lenders may charge you interest rates as high as 36 percent. If you have good credit, however, these rates drop to under 15.5 percent, which automatically translates to a cheaper loan.

2. Shorter loan terms

It’s not uncommon for bad credit loans to come with shorter repayment periods compared to traditional loans. A shorter repayment term means you’ll pay less interest than you would with a longer term, but it’s not without a downside.

The monthly payment is affected by the loan term. Because of this, the payment could be much higher than you can comfortably afford if you are taking out a larger amount.

3. Negative credit impact

If you take out a bad credit loan and the monthly payment stretches your budget too thin, you’re more likely to fall behind on the loan payments. If the loan becomes 30 or more days past due, the lender may report the delinquency to the credit bureaus.

This negative mark could drag down your score for up to seven years, impacting your ability to get approved for other credit products.

4. Calls from creditors

Unfortunately, adverse credit reporting isn’t the only negative result of falling behind on loan payments. The lender’s collection department may contact you with efforts to try and collect the overdue balance. The creditor may also sell the account to a debt collector who will attempt to recoup the outstanding balance through frequent letters and phone calls.

5. May need a co-signer

A co-signer may be your only option to get approved if you’ve applied with several online lenders but haven’t had much luck. This individual could be a friend or relative with good or excellent credit and a steady source of income.

Your co-signer will not receive funds from the loan, but they are equally responsible for paying it back. That means that if you encounter financial hardship and cannot make payments, the loan becomes the co-signer’s responsibility and their credit will also be impacted.

How to improve your credit score

Instead of settling for a bad credit loan with high borrowing costs, consider improving your credit score before applying. That way, you’ll have a better chance of qualifying for a personal loan with attractive terms in the future.

Before diving into strategies you can use to raise your credit score, you should understand how it’s computed.

Once you’re familiar with the FICO credit scoring model, here are some tips to help improve your credit rating.

  • Pay your bills on time: Payment history accounts for 35 percent of your credit score, so making timely payments on your debt obligations is vital. If any of your accounts reach 30 or more days past due, it’s more likely a late payment will be reported and significantly tank your credit score.

  • Reduce your credit utilization rate: This percentage is computed by dividing the total outstanding balances on your revolving accounts (or credit cards) by the credit limits. Ideally, your credit utilization rate should not exceed 30 percent.

  • Keep old credit accounts open: Credit age is another significant component of your credit score. If possible, keep old credit accounts in good standing open to preserve your credit age.

  • Only apply for new credit as needed: A secured credit card or credit builder loan can help improve your credit rating if managed responsibly. Otherwise, you should refrain from opening new credit accounts as they create hard inquiries that impact your credit score.

Bottom line

Bad credit loans are a convenient way to get fast cash, but they aren’t without risks. Evaluate the downsides before applying to determine if this loan product is best for your financial situation. And if you decide to move forward, shop around and get prequalified with at least three lenders to find the best offer available to you.

If you don’t need the funds immediately, improving your credit score could help you get better terms and save a bundle in interest and fees when you apply for funding in the future.

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