When a lender evaluates your eligibility for a loan, they investigate your ability to pay that loan back pretty thoroughly. Your ability to repay the loan is based largely on the ratio of your income to debt, but that's not the only factor that is important.
A lender will also evaluate your ability to repay the loan. This is represented by your credit rating, meaning that if you have bad credit (or other adverse circumstances such as defaults or arrears, a County Court Judgment or bankruptcy) you're less likely to have your application accepted.
If you have a reasonably good income to debt ratio and a poor credit rating, you might still get the loan, but it's going to be at a higher interest rate than is standard. These types of loans are called bad credit loans.
Know the Risks
If a bad credit loan is the only option you have for getting a loan, you'll need to understand the risks that are involved before you sign. Perhaps the most significant risk is simply that a bad credit loan costs more. Your interest rate is higher, and that means your repayments are also higher.
The problem is, if your credit rating is poor because your finances aren't good, you may be getting yourself into a very high risk situation. More simply, if you are forced to get a bad credit loan because your financial status is poor, the risk that you will end up unable to repay that loan is very high.
Another risk associated with bad credit loans is that you're more likely to encounter predatory lenders when searching for this kind of loan. Most conventional lenders are unlikely to offer bad credit loans, meaning you must look elsewhere for financing if your own credit is poor.
Minimizing the Risk
If you find that you're forced to consider a bad credit mortgage, it's helpful to know that there are some things you can do to reduce the associated risk.
- Try to emphasize your good points when meeting with lenders - for example, emphasize your stable work history or favourable income to debt ratio.
- Pay the largest down-payment you can afford to reduce the interest on the loan.
Two more important points are to choose your bad credit lender carefully, and to make sure you fully understand the terms and conditions of your loan.
- Avoid lenders who try to charge excessive fees, or who try and sell you unnecessary products or services associated with the loan.
- Don't let a lender pressure you into taking out a larger loan than you can comfortably afford.
- Find out what the penalty for early repayment is in advance (this is important if you plan to refinance).
Refinancing a Bad Credit Loan
People who take out bad credit loans often do so with the intention of later refinancing to a loan with more favourable terms once they have repaired their credit. This is particularly true when it comes to mortgages.
If you think you might try this, there are three important points to consider first.
- How much will refinancing cost?
- What's the penalty for early repayment on your bad credit loan?
- Is your credit rating high enough to make you eligible for a loan with terms that are favourable enough to offset the cost of the above two points?