To lenders, bad credit means risky lending. A person with a credit score under 630 can expect to pay drastically increased interest rates, if approved for a loan at all.
This fact can be especially difficult to face for people seeking debt consolidation loans. Heightened levels of debt often contribute to faltering credit scores, meaning that the more desperately someone needs debt consolidation, the more difficult it is to get.
However, just because it’s hard to get a debt consolidation loan with bad credit, that doesn’t mean it’s impossible. The 10 tips below break down the best way to secure a debt consolidation loan with less-than-stellar credit.
1. Understand how debt affects your credit score
Your credit score is a numerical expression of your creditworthiness; how safe are you to lend to? While there’s more than one way to determine a person’s credit score, most financial institutions use your FICO score when determining your creditworthiness.
FICO scores range from 300 to 850. While all lenders have their own definition of what a “good” credit score is, the breakdown is generally like this:
Bad: Below 600
Higher scores qualify for better loans. When it comes to debt consolidation loans, interest rates tend to start rising dramatically for anyone under 690 and get prohibitively high for anyone under 630.
Debt plays a major role in determining a person’s credit score. On top of payment history, two different factors play into the overall credit score calculation.
The first is the credit utilization ratio, which determines how much of a person’s total available credit is in use. The closer someone is to using all available credit, the worse this ratio will be for the credit score.
The second is debt-to-income ratio. This ratio reflects the relationship between a person’s income and his or her total debt burden. As debt increases and income decreases or stays the same, the worse this ratio will be for someone’s credit score.
In all, then, the deck is stacked against a person seeking a debt consolidation loan. The more significant the debt burden, the more difficult it is to gain approval for a loan, even as the financial situation becomes dire. To most lenders, the fact that the loan could help to eliminate a borrower’s financial woes is irrelevant; bad credit makes a lender less likely to lend no matter what.
Coming to terms with this fact may be difficult if you have bad credit and need a debt consolidation loan, but it’s the first step toward truly understanding your situation.
2. Try your bank or credit union first
Relationships matter in lending. For a potential borrower with bad credit, working with a lender that the consumer has a history with can make all the difference.
Because of this, individuals should talk to their current bank first when seeking a debt consolidation loan. A person’s bank will have much keener insight into a current customer’s financial history than another lender would and can bring that knowledge to the table in a lending decision.
This advice goes double for people who do their banking with non-profit credit unions. Credit unions are often community organizations devoted to the financial health of their members. They aren’t as concerned with maximizing profit as most other lenders are, and they may be willing to take a chance on someone with bad credit.
3. Shop around before you sign anything
All lenders are different. Some may offer drastically different loan terms than others to the same person and may be more willing to lend to an individual with poor credit. Shopping around for the best loan offer may take a little bit more legwork, but it’s definitely in a borrower’s best interests.
Before signing anything, borrowers should try to get at least three different offers from various lenders. They should be on the hunt for the lowest interest rates, sensible payment periods, and affordable monthly payments. In general, they should be able to determine which loan makes the most sense for their current financial situation while saving them the most money in the end.
Even a few percentage points of difference in interest rates can save someone thousands over the lifetime of a loan, so it’s worth holding out for the best offer possible.
4. Avoid payday lenders
For smaller sums and immediate financial relief, it can be tempting to seek out so-called payday lenders for short-term loans. Generally, these loans are an advance on your paycheck. You receive payment now, and when your paycheck clears, you pay the whole loan back.
Unfortunately, it’s not that simple. These loans often come with incredibly high interest payments that pile up quickly and never seem to go away entirely. More than that, the ability to get a quick influx of cash can be addicting, driving you to return to the payday lender the next time you’re financially strapped. It’s much easier to go back the second time than the first, so if you can, avoid it altogether. Instead, focus on long-term debt relief strategies.
5. Be wary of risk-based pricing
As we’ve already mentioned, bad credit can lead to loan offers with prohibitively high interest rates. There’s a name for this practice: risk-based pricing.
In general, lenders consider a bad credit score as an indicator that a borrower is at a higher risk of defaulting on the loan. On top of that, lenders also consider indicators such as employment status, income, and overall debt burden when determining if a borrower is risky to lend to.
If a borrower is officially classified as a risk, but still receives approval for some kind of loan, he or she will receive risk-based pricing, which usually leads to higher interest rates and other unfavorable loan terms.
If a borrower receives risk-based pricing, a notice should clearly state that fact. The notice should state that he or she has received higher rates than the average borrower, and include information about the negative factors included on the credit report that led to the risk-based pricing decision.
Receiving a risk-based pricing notice is a wake-up call for most borrowers. It’s a sign that it’s time to work on improving one’s credit score before accepting a debt consolidation loan.
6. Consider a co-signer
Adding a co-signer is a great way to sweeten the pot for a wary lender. Co-signers essentially act as a backup in case the primary borrower cannot pay back the loan on time. If the primary borrower can’t pay, the co-signer is on the hook to take over the loan. Having a co-signer minimizes risk for a lender, which in turn can lead to favorable interest rates on a debt consolidation loan. In extreme cases, having a co-signer can be the difference between approval and denial.
That said; co-signing on a loan is an extremely risky endeavor. The co-signer gets none of the benefits of the loan but stands to accept all of the risk of the loan if the primary borrower can’t keep up with it. Borrowers should be sure that they’ll be able to keep up with the loan before seeking co-signers, and co-signers should be aware of the risk of putting their name on a loan application.
7. Go for a secured loan
Much like seeking a co-signer, seeking a secured loan is a way to put lenders at ease. Secured loans are loans with collateral attached. This collateral might be the borrower’s car or some other valuable asset. The collateral doesn’t have to equal the total amount of the loan, but it should be valuable enough to pique the lender’s interest.
With a secured loan, if the borrower cannot keep up with payments, the lender can seize and sell the collateral. The presence of collateral reduces the lender’s risk, as it knows it will make at least some investment back. This makes lenders more likely to approve a loan or offer favorable interest rates.
Secured loans, however, are more risky for borrowers. Failing to keep up with the loan could result in losing valuable assets and falling deeper into financial disarray. Borrowers should be confident they’ll be able to keep up with their payments before accepting a secured loan offer.
8. Tap into your home equity, but be careful
Home equity loans are technically just another type of secured loan. However, they can be so effective and so unique that they merit their own discussion.
Homeowners build equity in their homes over time as they pay off their mortgages. Equity simply refers to the difference between a home’s total value and the balance remaining on the mortgage. A homeowner with a $300,000 home and only $100,000 remaining on the mortgage has built $200,000 in equity.
Tapping into this equity can be a great way to consolidate debt. Homeowners borrow against that equity, enabling themselves to take out sizable loans with the low interest rates associated with mortgages. With the average credit card interest rate around 15% and the average mortgage rate under 5%, this represents a huge level of potential savings.
Of course, this option is only available to homeowners, which automatically disqualifies many individuals in need of debt consolidation. Like any secured loan, it’s also risky, as lack of payment could result in the borrower losing the house. Still, in the right circumstances, a home equity loan can be a simple, cost-effective way to consolidate debt and save big over time.
9. Improve your credit score and try again
When it comes to credit scores, patience is a virtue. While it can take almost no time for a person to wreck his or her credit score, it can take months, even years, to improve it.
That said, improving your credit score can often be worth the wait. A good credit score is invaluable when it comes to applying for loans of any type, and sometimes the difference between approval and denial for a loan can be just a few points.
In general, individuals with scores under 600 will have great difficulty getting a debt consolidation loan and might be better off seeking an alternative. Individuals with scores between 630 and 699, however, might find that taking the time to improve their scores is well worth it, leading to more approvals and better interest rates that can save them a good deal of money in the end.
Unfortunately, there’s no overnight way for someone to improve a credit score. In general, a history of financial stability and health is necessary, as is a history of paying bills on time and paying down debts as much as possible. Consumers should regularly monitor their credit report for mistakes. Over time, these behaviors will lead to an improved credit score, which in turn leads to better loan offers.
10. If all else fails, consider the alternatives
For some borrowers with bad credit, debt consolidation loans are simply out of their reach. However, that doesn’t mean that they don’t have alternatives when it comes to debt relief. Many debt relief options are just as effective as debt consolidation and don’t qualify applicants based on their credit scores.
Non-profit credit counseling, for instance, is for individuals with bad credit. In credit counseling, individuals meet with professionals who help them get a grip on their finances, identify bad financial habits, and come up with a plan for paying down their debts in an affordable and timely manner.
Debt management plans are often the outcome of credit counseling sessions, but not always. With a debt management plan, an individual works with creditors to devise an affordable repayment plan that usually spans 3-5 years. Creditors appreciate this kind of predictability and are often willing to waive accumulated penalties and late fees in return, as long as the individual keeps up with payments.
Debt settlement can often be effective for debtors with bad credit as well. With debt settlement, a debtor ceases making payments to creditors and instead pays into a savings account managed by a third-party debt settlement company. That company negotiates with creditors on the debtor’s behalf, ideally taking the brunt of the creditors’ harassment due to non-payment. After a significant amount of money is in the savings account, the debt settlement company makes an offer to the creditors: take a reduced lump sum payment now and forgive the rest of the debt. The creditors often take the deal, desperate to make at least some of their money back. The process can be detrimental to a person’s credit score, but it allows him or her to get out of debt in a fast and cost-effective manner, making the trade-off worth it.
Are you curious about your debt consolidation options? Browse National Debt Relief for more information and discuss your options with a professional today.