How Do I Get Out of Debt with Bad Credit?

Bad credit can prevent you from qualifying for debt relief programs like low interest debt consolidation, and it can cost you thousands of dollars in interest to credit cards, auto and home lenders. The good news is there are debt relief options available to people with bad credit like non-profit debt management.

Debt Relief Options When Your Credit is Poor

How to Get out of Debt When You Have Bad Credit

Debt and bad credit are very close relatives, which should be no surprise since accumulating too much debt is the reason people have bad credit.

Unfortunately, the consequences of bad credit – high interest rate charges on credit cards, auto and home loans, even deposits for housing and utilities – are what keep people in debt. It’s a vicious cycle that feeds on itself and keeps consumers from gaining control of their finances.

A debt consolidation loan is one of the most common solutions to get out of debt when you have bad credit. Debt consolidation means taking out one loan and using it to pay off all your other unsecured debts. Debt consolidation loans simplify the bill-paying process, but they also should make things more affordable because of lower interest rates and lower monthly payments.

Repaying the debt consolidation loan in timely fashion also will help your credit score. Depending on what your current credit score is, it may not take more than a 25-30 point gain to change you from being a “bad credit” consumer to being a “good credit” consumer.

Debt Relief with Bad Credit

The truth is that there are a lot of loan options for people with bad credit and some are even tolerable. The one thing you must realize is that there is penalty for bad credit: You will play higher interest rates – sometimes considerably higher – than someone with good credit.

However, if you successfully repay the loan, and keep up with financial commitments while doing so, your credit score will improve and the cost for borrowing will drop.

Here are some of the places to find debt relief when you have bad credit:

  • Start at your bank. If you have a checking or savings account, you have a relationship with the bank. They want your business for the next 25 years. Giving you a personal loan is a step in the right direction for both of you.
  • Join a credit union. Their nonprofit status allows them to relax membership rules, loan standards, interest rates and fees. A very good idea for people with bad credit.
  • Ask family or friends for a loan. This is simultaneously the best and worst choice. Be responsible and business-like about this and all parties will benefit. Miss a couple of payments and the benefits – not to mention relationships – will disappear quickly
  • Debt consolidation loans. Banks or credit unions will give you a one-time loan to pay off all debts, then you make just one monthly payment to them. Be sure the interest rate is lower than what you pay on current debts and the payoff time doesn’t put you deeper in debt.
  • Home equity loan. If you have owned your home for several, you could borrow against the equity you have in it. The great thing about this is your credit score is not a factor. These are low-interest loans because the house serves as collateral.
  • Peer-to-peer lending. This is a mixed-bag for those with bad credit. Some peer-to-peer places won’t take applications unless your credit score is 640 or higher. Then there are places like Upstart, Prosper, Avant and First Financial that will take people with a 580 score or better. A low credit score could mean excessively high interest rates so be careful with this one.
  • Debt Management Programs. If you’re trying to eliminate credit card debt, this is a good place to find help. Any credit score is welcome. This is not a loan, but a good debt management program will reduce your interest rates and lower you monthly payments while also offering credit counseling that should help you long term.
  • Credit card loans. If you need a small loan that you can pay off quickly, using a credit card is an option. For example, if your car breaks down or you need a new refrigerator, but lack cash, using the credit card and paying it off with 3-6 months is one choice.
  • Debt settlement. If you’ve got bad credit and big bills – at least $15,000 or more – this might be an option. The positive is you might negotiate a deal that allows you to pay less than you actually owe. The bad news is that it will ruin your credit score for seven years and make it very difficult to get a loan of any kind.
  • Payday Loans. This is basically a two-week cash advance that should be a last-gasp, emergency-only option, and even then, you should be extremely careful. The typical charge for a payday loan is $15-$20 per $100 borrowed. That’s an annual percentage rate of 399%! That alone is scary, considering the highest interest rate on credit cards is usually 36%.

What Is the Best Loan Option with Bad Credit?

If you have decided that a debt consolidation loan is your best option for dealing with your debt, the next step is to choose a lender. Because everyone’s circumstances are different, it’s impossible to point in one direction and definitively say that you will solve your problem there.

It is possible to put choices in categories. The safest solutions would come from banks, credit unions, peer-to-peer lenders that offer debt consolidation loans or from credit counseling agencies that offer debt management programs. Each one is motivated to help you succeed, not just in eliminating the debt, but in improving your credit score for future opportunities.

Loans from family members, home-equity loans and credit card loans could be good avenues, but only if you are totally committed to repayment. Failure to repay loans to those sources could mean destroying a close relationship with family or friends; foreclosure on your home or seeing interest rates soar on your credit cards.

Debt settlement and payday loans are areas where you must be extremely cautious. Many lenders simply won’t deal with debt settlement companies and negotiations with those that do often take 2-3 years to settle. Beyond that, your credit score will drop, possibly by more than 100 points, and the negative mark is on your credit report for seven years.

If you can’t repay a payday loan, you have dug yourself a really deep hole. You could be faced with liens against your property; wage garnishment; overdraft fees from your bank; and possibly a day in court. At the very least, the lender will “rollover” your loan and add more interest to the balance due. A $300 loan that would have cost $345 if you had paid it back in two weeks, will cost nearly $400 two weeks later and go up from there.

What Happens When You Have Bad Credit?

The definition of bad credit is when you must accept high interest rates and very uncomfortable terms and conditions to borrow any amount of money. Or, worse than that, when lenders take one look at your credit history and completely reject your loan application.

Lenders categorize consumers based on their credit score. They draw a line at “650” or maybe “630” and if your score is below that mark, you have “bad credit” and are unwelcome.

In either case, if you have bad credit, it means you are considered a “high risk” and you will pay a high interest rate for any loan you get.

Risk-Based Pricing

Risk-based pricing is when lenders adjust interest rates on loans by estimating the risk the borrower may not repay. Someone with bad credit would be considered a high risk and thus receive a high interest rate. A low-risk borrower receives the lowest interest rates.

Every lender has its own formula for calculating risk, but most include credit score, outstanding debts, income, job status and debt-to-income ratio in arriving at the risk factor. Much of that information comes from your credit report.

If lenders gave you unfavorable terms on a loan and used your credit report in making their decision, you should receive a Risk-Based Pricing notice. If you receive one, you may contact the agency that supplied the credit report to verify that all the information in the report was accurate.

If you are overwhelmed by debt and need some relief from monthly payments, you may find that traditional debt help options are not available to you. For example, a debt consolidation company may be unwilling to lend to you, based on your credit score, or will give you a loan, but at such high interest rates that the consolidation loan offers no benefit.

How to Get a Loan with Bad Credit

If you’re not in a situation where you need extra money to get you through an emergency, it would be wise to spend some time cleaning up your credit score before applying for a loan. A 20- or 30-point bump on your credit score could be the difference between being labeled a bad credit risk and good credit risk.

And that will be the difference between paying interest rates so high they strangle your budget and interest rates that are manageable enough to give you some financial flexibility.

If you are conscientious about dealing with debt, any of the suggested choices could lift you out of the “bad credit” category and into a more favorable financial situation. It would help if you commit to on-time payments, making a budget (and sticking to it!) and using credit cards for emergencies only.

Here are some steps that should improve your credit score:

  • Clean up your credit reportDispute debts with creditors, collection agencies and reporting bureaus, especially if the debts are not yours. Get credit report education and take steps to improving your credit score through on-time payments and paying off old debts.
  • Make on-time payments. There might be no faster way to improve a credit score than making your payments on time every month. That is the biggest factor in computing your credit score.
  • Keep card balances low. Only use credit cards when absolutely necessary and pay down balances aggressively.
  • Don’t close unused cards. It’s great if you stop using a credit card, just don’t close it out. It helps your credit score in two ways: A) It helps on the “length of credit history” portion of your credit score and it improves your debt-to-income ratio.
  • Contact a nonprofit credit counseling agency. Credit counselors will review your financial situation and help you set up a manageable budget. Once you get there, they will offer some options on how to pay down debt, which quickly will improve your score.

 

How Credit Agencies Define Bad Credit

FICO, Experian, Equifax and TransUnion, the major credit bureaus and agencies in the U.S., deal in numbers so you won’t get a solid definition from them of what bad credit is. They prefer numeric categories that allow consumers to float from one ranking to another in any given payment period.

Experian, Equifax and TransUnion use the Vantage Score method, which goes from 300 to 850. Experian says it keeps scores for 220 million consumers, almost one-third of which (28%) have bad credit.

Here is a chart produced by Experian with categories broken down by credit score and number of consumers in each category.

From Super-Prime to Sub-Prime to Deep-Prime: Vantage Score Breakdown

  • Super-Prime Credit Scores: 781-850 … 48.4 million people
  • Prime Credit Scores: 661-780 … 79.2 million people
  • Near Prime Credit Scores: 601-660 … 28.6 million people
  • Sub-Prime Credit Scores: 500-600 … 50.6 million people
  • Deep Sub-Prime Credit Scores: Below 500 … 11 million

FICO, the score most often used by lenders in credit decisions, also ranks consumers on a scale of 300-850, but the FICO scoreboard is a little more stringent.

The top end of the FICO scale is a more inclusive, but the bottom ends is far more demanding, which again emphasizes how bendable the definition is for bad credit. Here is FICO’s scale.

From Excellent to Poor to Bad: FICO Score Breakdowns

  • Excellent credit: 750-or higher … 20.4%
  • Good credit: 700-749
  • Fair credit: 650-699
  • Poor credit: 600-649
  • Bad credit: Anything below 600 … 20.7%

A FICO survey in 2016 found that 20.4% of consumer were in the exceptional credit category (800-850) and about the same number (20.7%) were in the bad credit range (under 600).

The good news is that the number of people with bad credit has been declining every year since its peak of 25.5% in October 2010. In the six years since then, more than 17.5 million consumers have raised their credit scores above 600.

In fact, in 2016 the national average for FICO scores was 699, the highest in history.

Improving Your Credit Score eBook

How to Improve Your Credit – eBook

Credit Booster is designed to lead you through a step-by-step process to enhance your usage of credit and management of your debt. Our goal is to get you INVOLVED in planning and working toward your financial health and “wellness.” The format of Credit Booster should serve as a useful tool that you can use to realize these financial goals.

Consequences of Bad Credit

Bad credit is an epidemic in America, with more than half of all consumers strapped with such low credit scores that they can’t borrow at market rates.

Some families can’t finance a home, and poor credit means about a fifth of the population must turn to fringe financial services like payday loans or borrow from family members.

Low savings rates and stagnant incomes contribute to the problem. Bad credit hits families hard. They live close to the financial brink, just an expensive car repair or medical emergency away from insolvency. And they are often blocked from borrowing to buy homes, pay for cars and continue education that might lead to better-paying jobs.

Repairing your credit can take time and requires thoughtful money management. Ruining a credit score, however, might not take long at all.

Consider what happened to Jimmy, who lost his job as a welder during the Great Recession. Though he collected state unemployment insurance, it wasn’t enough to pay the mortgage or the expense of raising two small children.

Jimmy ran through his emergency savings in four months. When he stopped paying his mortgage, the bank foreclosed. His two credit cards also fell into default. By the time he eventually returned to work a year later, his family was living with a relative and his credit was flat-lined.

Jimmy’s credit repair job took several years. Even though his income bounced back, albeit at a slightly lower level than before the job loss, he started making payments on his credit card through a debt management program.

But the recovery had consequences. At first, he could only get a secured credit card. When his credit improved enough to qualify for a conventional credit card, he was shocked to learn that the interest rate on unpaid balances would be more than 25%. He also learned that he would have to wait several years to qualify for another mortgage loan.

For folks like Jimmy, a major financial setback is a double whammy. First there is the immediate loss of home and purchasing power of credit cards, then there’s the problem of re-establishing credit. Lending guidelines were tightened after the economic meltdown of 2008, making it even harder for those with tarnished credit to borrow money.

If your credit score falls in the lower regions of either the FICO or Vantage scale, the consequences on your financial life will range from annoying to outright depressing. Lenders use that score against you to impose higher interest rates on loans, longer payoff terms and bigger penalties for late payments. Each of those penalties gouge your bank account and damage your credit reputation.

Lenders make money when consumers repay loans. That is exactly what your credit score is meant to reflect: the likelihood that you will repay a loan. The lower your score, the less likely you are to repay that loan and the more likely you are to incur a penalty.

For example, when you have bad credit and want to buy a car, the lender is taking a bigger risk that you won’t repay the debt so you will pay far more for the loan than someone with a good credit score. If you need to borrow $25,000 with a poor credit score, you’ll pay around 12% interest on a 60-month loan. That means $556 a month payments and $33,360 paid out over the life of the loan.

The same loan for someone with good credit, paying 3% interest would run $450 a month and $27,000 over the course of the five-year loan.  That is $6,360 wasted because you have bad credit.

If you’re ready to buy a home with bad credit, the consequences are magnified. Many lenders won’t even deal with consumers who have bad credit. If they do, the interest rate on a 30-year, $100,000 home loan in 2017 would be about 5.5%. That would mean monthly payments of $568 and total payout of $204,480, more than double what you borrowed to start.

With good credit, the interest rate would drop to 4.97% ($535 per mo./$192,600 total) and with excellent credit, the rate would be 4.02% ($478 per mo./$172,285 total). That means bad credit cost consumers somewhere between $12,000 and $32,000 on a $100,000 loan.

The penalties for poor credit don’t stop at home and car buying. Insurance companies could refuse to write car, home or life insurance policies because of bad credit. If they do write the insurance, your rates could be as much as $1,000 higher every month.

Renting an apartment with bad credit is also challenging; utility and cell phone companies require larger deposits and employers who use credit history as part of the hiring process, may disregard your application because you have bad credit.

Finally, your bad credit could lead to a barrage of phone calls from debt collection agencies trying to run down payments that are past due.

In other words, bad credit is going to make your financial life difficult at best and costly at the worst.

“The first thing any lender wants to know is whether you’ve paid your credit accounts on time,” Can Arkali, principal scientist for analytics and scores at FICO, said. “That negative information has a considerable impact on your credit.

“The important thing to keep in mind is that the impact of negative payment information will be less damaging over time if you keep your credit obligations in good standing.”

In other words, make on-time payment credits every month and over the course of time, you can get rid of the “bad credit” label.

Sources:

FICO (2017) What are the minimum requirements for a FICO® Score ? Retrieved from http://www.myfico.com/crediteducation/questions/requirement-for-fico-score.aspx

Scott, P (2017, January 25) Getting a Mortgage After Bankruptcy and Foreclosure. Retrieved from http://www.investopedia.com/articles/personal-finance/032715/getting-mortgage-after-bankruptcy-and-foreclosure.asp

Cetera, M (2016, May) Survey: Surprisingly Few Millennials Carry Credit Cards. Retrieved from http://www.bankrate.com/finance/consumer-index/money-pulse-0616.aspx

O’Shea, B (2016, May 27) FICO XD: A Credit Score for Those With No Credit. Retrived from https://www.nerdwallet.com/blog/finance/fico-xd-credit-score/

Can I Consolidate My Debt With Bad Credit?

Learn the credit score cut-off for a debt consolidation loan and about other debt relief alternatives for people with bad credit.

Learn More

How To Rent An Apartment With Poor Credit

Practical tips that will help you rent an affordable apartment when you have poor credit: including using a co-signer, renting a family-owned apartment and paying a larger deposit.

Learn More

Know Your Rights With Debt Collectors

Learn what debt collectors can and can’t do attempting to collect money from you and where to report violations.

Learn More