What to know about high-risk loans and why you should avoid them

A minimum credit score usually is required to get a loan, so borrowers with poor credit have a tougher time borrowing money. If your credit score could be better and you need to borrow some cash for an emergency or unexpected expense, you may be tempted by a high-risk loan, such as a payday or title loan. Before you apply for one, it’s best to understand how they work and understand the risk for you as a borrower.

While Rocket Loans℠ doesn’t offer high-risk loans, we want you to understand the pros and cons of all your lending options.

What are high-risk loans?

Compared with traditional personal loans, high-risk loans usually are for relatively small amounts of money paid back over a short term with a high interest rate. These loans are considered riskier for the lender because the borrower is more likely to default on the loan.

Lenders compensate for the increased risk by charging a high annual percentage rate, which includes finance fees. They also may require the borrower to put up some collateral, like a vehicle or another asset. They also may charge the borrower fees to rollover or extend the loan if they can’t afford to pay it off quickly.

Types of high-risk loans

There are several common types of high-risk loans. Here is some additional information about payday loans, car title loans, pawnshop loans, and high-risk personal loans.

Payday loans

Payday loans are short-term loans typically limited to $500 or less. They use your next paycheck as collateral. The repayment term on a payday loan is short, usually 2 weeks or until your next scheduled paycheck.

Payday loans have interest rates as high as 400%. They also usually have significant costs and fees. The high cost of repaying these loans often requires borrowers to roll over the debt into another loan, creating a snowball debt effect that can be very difficult to get out of. Because of this, 21 states and the District of Columbia ban payday loans.

Auto title loans

Car title loans use your vehicle as collateral. The lender keeps your car title until you pay off the loan. Loan amounts tend to be 25% – 50% of your vehicle’s value, but this can vary by lender, as well as which state you are in, as some states regulate title loans.

The APR on title loans can be as high as 300% and you may have to pay a finance fee of around 25%. Another important thing to know about car title loans is that some lenders require you to buy add-ons, like a roadside service plan, which increase the cost of the loan even more.

Like payday loans, title loans are meant to be repaid quickly. Borrowers may be unable to pay their loan balance in full when the loan is due and roll over the loan, often with additional fees. If you default on the loan, the lender can repossess your vehicle and sell it to recoup the loss.

Pawnshop loans            

Pawnshop loans also are secured by collateral, usually valuable personal possessions such as jewelry, electronics, musical instruments, or collectibles. Pawnshop loans usually let you borrow 15% – 60% of an item’s resale value.

Pawnshop loans are typically small. Interest rates can be as high as 200% and most lenders charge additional fees on top of that. If you don’t repay or roll over the loan, the lender keeps your item and can sell it to recoup the funds you’ve borrowed.

In most cases, pawnshops will not report a default to credit bureaus because forfeiting the collateral is considered repayment.

High-risk personal loans

Some lenders offer high-risk personal loans to borrowers with a low credit score or no credit history. These loans usually charge high interest rates and fees, and set strict repayment terms. Lenders offering high-risk personal loans often require borrowers to have a minimum income and to post collateral to secure the loan.

What makes a borrower high-risk?

Your credit score is a key factor lenders use to decide how much risk they are taking in lending you money. Those with a credit score above 580 – 600 are typically viewed as low-risk borrowers, while scores below this range are seen as higher risk.

Other factors that make a borrower high-risk to lenders include:

• High credit card balances
• A credit history showing defaults or late payments
• A short credit history
• Self-employment or the absence of full-time employment
• A debt-to-income ratio higher than 36%
• A recent bankruptcy filing

High-risk borrowers are more likely to default than borrowers with a good credit profile. It’s a good idea to regularly check your credit report and credit score to know what lenders would see if they pull your data.

A soft credit pull: What high-risk lenders review

When you apply for a loan, most lenders conduct a hard inquiry on your credit history,  review your credit score, verify your income, and calculate your DTI ratio.

High-risk lenders often advertise that they do not check credit scores and review only factors such as your income and employment, verify your identity, and ensure you’re 18 or older. Lenders also may require you to have a bank account.

Signs of predatory high-risk loans

Many high-risk lenders are known to practice predatory lending tactics. Here are some signs that you’re dealing with a predatory lender:

• They charge high fees and interest rates.
• They offer no or little transparency around fees, APR, etc.
• They try to sell you add-ons at extra costs.
• They don’t require proof of income.
• They have few, if any, positive customer reviews online.

You’ll want to avoid lenders that present any or all these signs.

Why you should avoid high-risk loans

A high-risk loan may seem like an easy solution to securing the cash needed for an emergency expense, but these loans often lead to more financial trouble.

First, interest and fees add up quickly, particularly with rollover fees if you need to extend your due date. You could end up paying a huge cost for borrowing a relatively small amount.

Second, since many high-risk loans require collateral, you risk losing any assets you used to secure the loan if you default. In the case of a car title loan, you could lose your main mode of transportation.

Lastly, the short repayment term increases the risk you’ll need to roll over your loan and incur additional fees and interest. You could find yourself trapped in a debt cycle and need another loan just to get out of it. The high fees and interest rates on these loans often make them difficult for individuals living paycheck to paycheck to pay them off.

Alternatives to high-risk loans

Here are some safer alternatives for high-risk borrowers.

Secured personal loans

Some lenders offer secured personal loans. You put down collateral to compensate for a lower credit score. These loans are offered by traditional lenders and offer lower interest rates and better terms than high-risk loans. Make sure you can afford the monthly payment to avoid losing your collateral.

Consulting your financial institution

Consider meeting with a representative at your bank or credit union to discuss your financing options. Having an existing banking relationship could offer benefits for borrowers, since some financial institutions can offer special deals for long-term clients. It also may be easier to go through the loan process with a financial institution that you know.

Apply with a co-signer

A co-signer can give your loan application a boost. Just remember, your co-signer will be responsible for the loan if you default. Applicants with a qualified co-signer may qualify to borrow more money at a lower interest rate.

Explore online lenders

Online lenders may be more flexible in their credit requirements than brick-and-mortar banks and credit unions. They may be able to focus more on your income when deciding whether to approve you for a loan. Peer-to-peer (P2P) lending platforms also help, connecting individuals who need money with individuals who are willing to lend it.

Consider a family loan

You also can ask family members or a friend for a loan. The lender and borrower will need to agree on the interest rate and term for a family loan, but you could have no interest rate at all if your family member is OK with it. While it may seem like a great option to get a loan from a family member, there are potential downsides. You may feel that asking for a loan from friends or family members could strain the relationship. Although family loans are relatively informal, it’s still wise to have an attorney draw up a contract.

Improve your credit score

You can improve or build up your credit score in a number of ways. For example:

• Pay your bills on time.
• Pay down debt to decrease your DTI ratio.
• Seek credit counseling.
• Identify and correct errors on your credit report
• Become an authorized user on someone else’s credit card.

Raising your credit score can help you qualify for more traditional loans, including a personal loan.

FAQ

Here are answers to common questions about high-risk loans.

What is considered a high-risk loan?

A high-risk loan usually has a high interest rate, short repayment term, collateral requirements, and a relatively low loan amount. Lenders will typically forego a credit check and approve a loan based on a borrower’s income or other qualifications.

Which loan has the highest risk?

Unsecured loans are the riskiest for lenders to approve, because the lender doesn’t require collateral for reclaiming their lost funds if the borrower defaults. Payday loans don’t require collateral but can charge an exorbitant interest rate and extremely high fees.

What credit score is considered a risk?

A lender likely will consider a FICO® credit score lower than 580 – 600 to be high-risk. The higher your credit score, the less risk you pose for a lender.

Who gives high-risk loans?

While there are reputable lenders that offer high-risk loans, it’s important to watch out for predatory lenders. If your lender charges high fees and interest with minimal transparency, that could be a red flag that you should avoid that lender.

The bottom line: High-risk lenders are risky for your financial health

Borrowers with a poor credit history may seek out high-risk loans for quick and accessible funding, but it’s a good idea to consider the drawbacks. High-risk loans can be a financial gamble, since they usually come with high interest rates, finance fees and rollover charges. They also may require collateral. Paying back a high-risk loan could drain your finances and leave you in a cycle of debt..

Want to view your options for a personal loan? Start an application today with Rocket Loans.