What is a second chance loan?
A second chance loan is a type of loan intended for borrowers with a bad credit history, who would most likely be unable to qualify for traditional financing. As such, it is considered a form of subprime loan. A second chance loan usually charges a much higher interest rate than that which would be offered to borrowers who are considered to be of lower credit risk.
How a second chance loan works
Second chance loans are often offered by lenders specializing in the subprime market. Like many others risky loans, a second chance loan can have a typical term to maturity (like a 30-year mortgage), but it is generally intended for use as a short-term financing vehicle. Borrowers can get cash now and – by making regular and on-time payments – start repairing their money. credit history. At this point, they may be able to get a new loan on better terms, which will allow them to pay off the second chance loan. The high interest rate on a second chance loan prompts borrowers to refinance as soon as they can.
Another type of second chance loan has a very short term, sometimes as little as a week or two. Rather than being repaid over time, this loan variant must be repaid in full at the end of that term. These loans tend to be for smaller amounts, like $ 500, and are often offered by payday lenders, who specialize in high-interest, short-term loans, scheduled to coincide with the next paycheck. ‘borrower.
Second Chance Loans can help borrowers with poor credit, but due to their high interest rates, they should be paid back as quickly as possible.
Pros and Cons of Second Chance Loans
While second chance loans can help borrowers with bad credit history rebuild their credit – and may be the only option if they need to borrow money – these loans come with substantial risk. .
One is that the borrower will be unable to repay the loan or obtain other financing to replace it. For example, lenders frequently offer second chance loans in the form of a adjustable rate mortgage (ARM) known as 3/27 ARMS. In theory, these mortgages, which have a fixed interest rate for the first three years, give borrowers enough time to repair their credit and then refinance. The fixed rate also gives the borrower the convenience of predictable monthly payments for the first three years.
However, at the end of this period, the interest rate begins to float based on an index plus a margin (called the fully indexed interest rate), and payments can become unaffordable. Additionally, if the borrower has lost their job or suffered other financial setbacks in the meantime, refinancing to a better loan at cheaper rates may not be possible.
Short term second chance loans from payday lenders have their own drawbacks. One is their often exorbitant interest rates. As the Federal Bureau of Consumer Financial Protection points out on its website, “A typical two week payday loan with fees of $ 15 per $ 100 equates to an annual percentage rate (APR) of nearly 400%. . ”
Before borrowers even consider a second chance loan, they need to make sure that they are not eligible for traditional financing from a bank or other lender, which is usually cheaper and less risky.