One question – maybe the first question – to answer before taking out a personal loan, is whether the math adds up in your favor.
Personal loans can be a good way to pay off high-interest debt, like credit cards, but only if the interest rate on the loan is considerably lower than the interest rate on your card.
That dynamic is dangerous, especially when it feels like your personal debt is reaching the crisis level. A potential borrower in a serious financial bind is an easy mark for predatory lenders, who are adept at making too-good-to-be-true offers as a way out.
They know you think a bad credit score limits your options, so their offer of a quick-and- easy payday loan or title loan or other high-risk personal loan can be difficult to resist.
But beware. Those loans come with frightfully high interest rates and often include fees to match. They are debt traps, in the same way the urge to use a credit card to pay off a utility bill is. Sure, the water company gets paid, but now the credit card company is the wolf at your door. Peter? Meet Paul.
However, loans that come with low interest rates are available for those who qualify. (We’ll get to how to qualify for them a little later.) The point: Be careful and don’t despair. Other solutions to a personal debt crisis are possible.
What Is a High-Risk Loan?
They’re called “high-risk loans” because they generally go to borrowers who don’t have a solid track record of repaying debts, which could make default on the loan more likely. In many cases, these are unsecured loans, meaning they don’t require the borrower to put up anything to use as collateral. The “risk,” then, is to the lender, who might not be repaid.
To protect against that, a high-risk loan comes with an extremely high interest rate and, sometimes, substantial fees. If only partial repayment repayment is made, the big-number interest will help the lender recoup some of the loss.
Because the interest rate is high, predatory lenders make obtaining their high-risk loans as easy as possible. Many such loans, in fact, are available online and don’t require the borrower to provide much, or any, proof of income. If you’re the borrower, that should be a red flag. When it’s that easy, it’s time to dig into the details to be sure you know everything expected from your end of the deal.
Here are some types of loans considered to be high-risk, and why:
- Bad credit personal loans. When a low credit score makes a conventional loan impossible, some lending institutions will approve a personal loan for use in a financial emergency. But it probably won’t make the borrower’s life easier for long, as it likely will involve double-digit interest rates (maybe as high as the ones you’re already paying on your credit card), very strict monthly payment terms, extra fees and possible penalties.
- Bad credit debt consolidation loans. Some institutions will approve a loan that allows the borrower to combine credit card bills and other unsecured debts to be paid off over time with just one payment per month. The lower the credit score, though, the tougher the terms of a bad credit debt consolidation loan will be, starting with a high interest rate. And if you keep acquiring debt after you get the loan, you’re just digging a deeper hole.
- Payday loans. A typical payday loan can involve an annual percentage rate (APR) of 399%. They’re for relatively small amounts, generally $500 or less, with fees, usually $15 (and it could be more) for every $100 you borrow. That’ll take a significant bite out of your next paycheck. These loans typically come due on your very next payday, so they’re about as short-term as they come.
- Home Equity Line of Credit (HELOC). If you’ve paid off enough of the purchase price of your home, you can use it as collateral to qualify for a home equity line of credit. HELOCs work like a credit card, meaning you only pay interest on the part of the line of credit you use. (With a home equity loan, on the other hand, you get a lump sum amount and pay interest on the entire amount you borrowed.) Be careful, though. If you can’t pay it off, you could lose your home to foreclosure.. At the least, a HELOC will reduce the equity you’ve built. And it usually comes fully loaded with heavy fees.
- Title loans. Got a car, or some other valuable asset to which you own the title? You can use that title to secure a personal loan. Because you’re willing to put up your wheels as collateral, the lender won’t care so much about your credit history. But you could be paying an APR of as much as 300%, and many states can require a single repayment of the entire principal, interest and fees, usually about a month after the loan is granted. If you default? You can lose your car.
What Is a High-Risk Borrower?
Lenders label a loan applicant as a high-risk borrower when the applicant’s low credit score and/or poor credit history means he or she has a high possibility of defaulting. To a lender, a high-risk borrower likely has few, if any, other options for a loan.
These are some of the factors that can lead to a low credit score and a designation as a high-risk borrower:
- Keeping high credit card balance(s)
- Multiple credit inquiries, especially in a short period of time.
- A history of late payments on loans or credit cards.
- Part-time employment, or a self-employed status without a history of tax returns.
- A recent history of bankruptcy.
Generally, a credit score below 600 (the FICO Score, the most widely-used scale, ranges from 300 to 850) is likely to identify a loan applicant as a high-risk borrower. In 2021, the share of Americans with credit scores under 600 was 15.5%, according to FICO.
As you investigate loan possibilities, it will be helpful to check your credit report to know if you will be considered a high-risk borrower. The three major credit reporting agencies – Experian, Equifax and TransUnion – provide each individual one free credit report per year.
Reasons People Take Out High-Risk Loans
In the face of immediate financial crises, a high-risk loan can be a reprieve for a high-risk borrower from emergencies such as medical issues, car repairs, a sudden plumbing catastrophe or overdue utility and credit card bills. Desperate times, in other words.
Under certain circumstances, though, there are perfectly valid, productive reasons for taking one out even if your credit score is low.
One of the best reasons to take on a high-risk loan is to begin the process of fixing your finances. And yes, adding a loan with a high interest rate to your already-established debt might sound counter-intuitive. But with the right discipline and adherence to a strict repayment plan, a high-risk loan can be used to consolidate debt.
Make on-time payments for the consolidated loan and your credit score will improve. On-time payment count for 35% of your credit score. Do this right and you can start to mend the error of some of your earlier ways.
But remember the risks. A debt consolidation loan can backfire if you don’t have a plan to repay it, or don’t stick to the plan you put in place. Defaulting on that loan will sink your credit rating to new depths.
Should You Use a High-Risk Loan to Pay Off Debt?
The motive (paying off debt) can be right using a high-risk loan to pay off debt, but the method has to be right, too.
A high-risk loan to consolidate your debts might make sense, but only if you can find one that carries a lower interest rate than, say, your credit cards and other individual loans you’re already obligated to pay off.
According to the most recent Federal Reserve numbers, credit cards charge an average interest rate of 15.5%, while the average personal loan carries a 9.58% interest rate and home equity lines of credit fall between 6% and 9%.
However, the interest rates on other high-risk loans – bad credit, payday, title – generally are much, much higher, sometimes 300% to 400% or more.
Here’s the rub: The lower your income and credit score, the higher the interest rate on a high-risk loan is likely to be. If you are a high-risk borrower and can find a lender willing to work with you, recognize that the terms of the loan being offered aren’t going to favor you.
So, make sure you do the math. Add up how much you owe altogether, and then add up your total monthly payments and the interest rates you’re paying. That way, when you shop around for a high-risk loan to consolidate those debts, you’ll know how much you need, and you’ll be able to compare the amount of the loan’s single monthly payment against your current monthly combined total.
If the monthly consolidated loan payment is smaller, you’ll start saving money. But, again, as soon as you stop making the single monthly payments, the saving stops and you’re back in that no-exit debt loop.
Reasons to Avoid High-Risk Loans
The last thing you need is to put yourself in a position where you are going to owe more than you thought you were borrowing, so make absolutely certain you can afford the monthly payments on the high-risk loan you are considering. If you can’t, you could be looking at even deeper debt than you are already carrying, and you could further jeopardize your ability to get the next loan you need.
Predatory lenders, especially, can make it difficult to understand exactly what is involved in paying back a loan. As you shop around for a high-risk loan, here are some reasons to walk away from an offer and look elsewhere:
- If you haven’t been told what the annual percentage rate (APR) of the loan is.
- If you don’t know what the loan is going to cost you in terms of extras such as a loan origination fee, a prepayment penalty or a late payment fee.
- If the lender doesn’t bother to check into your credit. (Chances are that means the lending company intends to cover its risk with fees and an exorbitant interest rate.)
- If the lender doesn’t ask what your income is.
- If the lender isn’t licensed.
- If you can’t find positive customer reviews online for the company or at the Better Business Bureau.
- If the lender tries to talk you into taking out a bigger loan than you need.
High-Risk Loan Alternatives
Big interest rates. Heavy fees. Other associated risks. For those reasons, a high-risk loan should be a last resort in a time of financial difficulty.
That’s especially true because there are other bad credit debt-relief options for people whose low income or poor credit history make it difficult to get conventional loans. The options listed below can help pay off your credit card debt. They can keep your credit rating from further ruin. They can even improve your credit score.
A list of some alternatives to high-risk loans:
- A debt management program through a nonprofit credit counseling agency can set up an affordable monthly budget with a tailored payment schedule that includes reducing the interest rate to as low as 8%, sometimes even lower. This isn’t a loan and credit scores aren’t considered in eligibility for the program.
- Credit counseling is a free service offered by nonprofit agencies in which a certified counselor develops a plan to help you out of financial trouble based on your specific circumstances. The counseling can be done over the phone or online.
- Credit card debt forgiveness programs allow consumers to pay 50%-60% of what they owe over a three-year period to settle their credit card debts, and their creditors forgive what’s left.
- For-profit debt settlement companies negotiate with your creditors to settle for a lower amount than you owe, and ask you to make payments to the company rather than to your creditors. Most unsecured debt is eligible for debt settlement. The company charges a fee of 15%-25% of the debt being settled.
Talk to a Financial Professional to Explore Better Debt Relief Options
A cash-flow crisis and mounting debt aren’t much fun. It might feel as if you have little choice except to take out a high-risk loan, especially when the quick-fix offer from a lender sounds so good and so easy.
But before you commit to even more debt with a high interest rate, make sure you talk to a nonprofit credit agency such as InCharge Debt Solutions about more sensible ways out of your predicament. Your discussion with a credit counselor can help you explore better debt relief options and provide free help to create a budget to save money and start you on the path to control of your finances.
It’s a simple phone call or online reach-out to ask what the best possible solution might be to your specific financial issues. If the answer is a debt management program, the credit agency can get you started on it right away.
If you’re already struggling with payments on high-risk loans, a credit counselor can suggest a repayment plan that that will work within your means.
About The Author
Michael Knisley writes about managing your personal finances for InCharge Debt Solutions. He was an assistant professor on the faculty at the prestigious University of Missouri School of Journalism and has more than 40 years of experience editing and writing about business, sports and the spectrum of issues affecting consumers and fans. During his career, Michael has won awards from the New York Press Club, the Online News Association, the Military Reporters and Editors Association, the Associated Press Sports Editors and the Sports Emmys.
- N.A. (2016, May 18) Single-Payment Vehicle Title Lending. Retrieved from https://files.consumerfinance.gov/f/documents/201605_cfpb_single-payment-vehicle-title-lending.pdf
- N.A. (ND) What to Know About Payday and Car Title Loans. Retrieved from https://www.consumer.ftc.gov/articles/what-know-about-payday-and-car-title-loans