Second-Chance Auto Loans: Risks and Rewards

In many parts of the country, owning a car is a necessity for steady employment and everyday life. However, if you have poor credit, obtaining financing for the vehicle you need won’t be easy. One potential solution is a second-chance auto loan. Designed for borrowers with lower credit scores, second-chance loans come with both drawbacks and benefits. Here are some tips to help you understand the pros and cons of these loans and make a decision that’s good for your financial health.

Understand the costs

When you take out a second-chance auto loan, it’s likely to come at a much higher cost than a standard auto loan. That’s because second-chance borrowers are more likely to default, and the lender is taking on more risk.

As a general rule, the lower your credit score, the more you’ll pay in interest rates. This is especially true for second-chance loans. Investopedia contributor Will Kenton writes that second-chance loans generally apply to borrowers with FICO scores under 620. Interest rates for these loans are significantly steeper than they are for borrowers with great credit — sometimes three to five times as high.

Depending on the lender you choose, you could be subject to other costs as well. According to Dana Dratch, a financial writer for Credit Karma, lower-credit borrowers are sometimes required to make larger down payments or pay extra fees at the dealership. Some lenders even charge prepayment penalties if you pay off your loan earlier than expected.

Do your homework

If you’re considering a second-chance auto loan, it’s imperative to do your research before committing to anything. Before you seek a loan, get acquainted with your credit report so you know your financial situation. Carefully assess how much you can afford to pay for a vehicle. Setting a budget will help you handle sales pressure and avoid taking on monthly payments you can’t handle.

You’ll also want to spend plenty of time doing homework on potential lenders. A range of financial institutions offer second-chance auto loans, and their terms and fine print can vary widely, so be sure to shop around. Once you narrow down your options, try to get prequalified for a loan before you head to the dealership. Writing for U.S. News & World Report, John M. Vincent notes that this strategy will help you better stick to your budget and put you in a stronger position to negotiate a good deal if you finance through the dealer. As you seek out loans, Consumer Affairs researcher Kate Williams recommends keeping all your applications within a two-week timeframe to minimize the effect that credit inquiries will have on your score.

Know the risks and rewards

Taking out a second-chance auto loan offers both risks and rewards. Among the risks: If your interest payments are too high, you could end up going “underwater” on the loan — owing more on the car than it’s worth. And if you don’t keep up with payments and default on the loan, your vehicle could be repossessed, sinking your credit even lower. Second-chance auto loans come with rewards, too. They provide a path for you to obtain reliable transportation even when you’re struggling financially. As you make payments on time and pay off the loan balance, your credit score will improve, putting you in a better position for future purchases.

A second-chance auto loan is a useful financial tool, but one to be used with the greatest of care. If you need to apply for one, make sure you do so only after conducting in-depth research, consulting with your financial institution and weighing whether the risks and rewards make sense for your situation.

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