Want to know how to get a loan with bad credit? It’s possible, because many lenders offer personal loans for bad credit. The key to loan approval is proving that your income is sufficient to repay the loan.
Here’s what you need to do before applying.
- Estimate your credit score
- Add up your income and debts
- Make sure you can afford to pay your loan on time
If you have a low credit score, a personal loan can help you increase it.
Income needed for a personal loan
Most personal loan programs don’t establish a minimum income to get approved. However, they do consider the relationship between your income and your monthly payments. That relationship is your debt-to-income ratio, or DTI. Debts include:
- Housing expense, whether you have a mortgage or pay rent
- Minimum payments on your credit cards and other lines of credit
- Monthly payments for installment accounts like auto financing and student loans
- The payment on your new personal loan
If using a personal loan to consolidate debt, your DTI should include the new personal loan. If you plan to use the personal loan to pay off other debts, don’t include them in your DTI. Most lenders set the maximum DTI they’ll accept between 35 and 50 percent. However, it’s harder to get approved for loans for people with bad credit if your DTI is high.
How to calculate your DTI for a personal loan
Calculating your DTI is not hard. Just go through these simple steps.
- Add up all of your monthly debt payments
- Add up your monthly income sources. Use the before tax amounts, not your after-tax numbers
- Divide the total debt payments by your total gross (before tax) income
Suppose that you earn $4,000 per month before taxes. And that you have these debts:
- Car payment: $200
- Credit cards, total of minimum payments: $300 per month
- Rent: $1,200 per month
Currently, your DTI equals 43.75 percent. That’s $1,750 / $4,000.
But if you use a $10,000 personal loan to pay off that credit card debt, at 20 percent over five years, your payment is $265. This drops your DTI to 41.63 percent, which should improve your chances.
How a personal loan can increase your credit score
Bad credit tends to cause more bad credit. Because when you have a low credit score, lenders charge you higher interest rates — up to 36 percent for traditional credit cards, for instance. This makes loans harder to repay, and you are more likely to miss a payment. Which causes your score to fall lower.
You can stop this cycle with a personal loan for debt consolidation. It can help increase your score by replacing credit card balances with an installment balance. Your credit card balances, and utilization, will show on your credit report as zero.
Not consolidating debt? Online loans for bad credit can help raise your credit score, or at least prevent it from falling further, if you use them for larger purchases instead of credit cards. That will keep your utilization lower, and your score higher.
What is utilization?
Your utilization equals the amount of credit you use divided by the amount you have. High utilization means that you’re using too much of your available credit. Utilization comprises 30 percent of your FICO score. Here’s how utilization works.
If you have $10,000 of available credit, and use $9,000 of it, your utilization is 9,000 / 10,000, or 90 percent. You’ll trigger alarms at the credit bureaus. But pay your debt down to $4,500 and your utilization falls to 50 percent. Then watch your score climb.
People with the very best credit scores use less than 10 percent of available credit and don’t carry balances. Those with better-than-average scores use about 30 percent.
Paying off debt month-by-month is good for your financial health, and for your credit score.
Because your installment loan is closed-end, your balance will fall with every monthly payment. As long as you don’t add to your other borrowing, you will owe significantly less once you repay your personal loan. And you will have months of positive payment history, which comprises 35 percent of your FICO score.
Your personal loan can replace several payments with one payment. This can make budgeting easier, and staying on track more likely. Make your personal loan payment on-time every month, and your credit score should be significantly higher by the time you pay it off. Your good history will help you save the next time you borrow, and you’ll be on the way to a credit score you can be proud of.
Credit score to get approved
Understand that if you want a personal loan with a 550 credit score, you’ll need a pretty low DTI. That’s because lenders look at a whole package. They might accept a 550 credit score, or a DTI up to 50 percent, but it’s unlikely that they will accept a 550 credit score and a DTI of 50.
However, lenders also understand that there are many reasons for a low credit score. Not all of them mean you have bad debt management skills. You may get a personal loan with a low credit score and a high-ish DTI if the reason for your low score is one of these:
- Short credit history
- Too few active accounts
- Too many accounts with balances
- High utilization of credit
So if your credit score is low but not due to late or missing payments or serious events like a collection or repossession or legal filing, you may get a personal loan.
Loans to avoid
Not all personal loans are created equal. Some products advertised as “personal loans for bad credit” are in fact secured by your auto title. You’ll get high interest rates and fees, and may find yourself trapped in a loan you can’t repay. You might even lose your car.
Other loans you might see include “personal loans with no credit score.” They are often actually payday loans, which have extremely short terms and high costs. You’ll never improve your finances with these, and your credit rating won’t get any better.
Some “bad credit” personal loans have annual percentage rates (APRs) as high as 3,600 percent! They are traps for the unwary and can suck you into a cycle of debt you’ll find it hard to escape.
But now you know better.