People with bad credit finance cars all the time. They pay more than people with good credit. That shouldn’t come as a surprise — interest rates can vary pretty dramatically. Someone with good credit may get financed at a very low 2% APR, while someone with very bad credit may pay 18%, 20%, or even 24%.1
Why is your rate higher if you have bad credit?
A person with a 490 credit score is seen as a higher risk than a person with a 710 credit score. Put yourself in the bank’s shoes — who would you rather lend money to? A person who has an established history of paying his bills late / not at all, or a person who has an established history of paying all his bills on time?
No, having bad credit does not make you a bad person all by itself. There are tons of reasons why a person might have bad credit, and you can’t control all of them. But bad credit does make you a higher risk. The bank compensates for that by charging a higher interest rate. They know that some of the bad credit loans that they make will default. The higher rates allow the bank to remain profitable in spite of that.
Interest rate is the main, and most obvious reason that you pay more for a car loan when you have bad credit. The other reason is much more secretive, and no one seems to want to talk about it. The reason is the bank fee.
Some lenders, such as RoadLoans, Santander, and Drive Financial2, specialize in financing folks with truly terrible credit. They charge high interest rates, they often require a larger down payment, and they charge bank fees. The bank fee is a fee charged by the lender to the dealer as a condition of approval.
This fee can range anywhere from $1,000 all the way to $3000. Let me say that another way: Some lenders charge the dealer up to $3,000 to finance a customer.
Let me give you an example of how this works in the real world. Lets say you have bad credit, and you want to buy a $10,000 car. You find a nice one at your local dealer. When the approval comes back, it’s at 18% interest and a $3,000 fee. This is the only approval – every other lender the dealership tried declined.
What is the dealer supposed to do? Well, in most states, he’s supposed to sell you the car for $10,000 and eat the fee. He’s supposed to do that. He doesn’t. He can’t. The dealer probably owns that $10,000 car for about $8,000. If he sells it to you for $10,000 and eats the $3,000 fee, he just lost $1,000 to sell you a car. He won’t stay in business very long if he keeps doing that.
So, he’s left with two choices. He can decline to sell you a car. After all — he wants to play by the rules. He’s not supposed to charge you more, but he can’t afford to sell you the car. Dealers don’t often make this choice.
The option most commonly chosen is to sell you the car — for $13,000. Yes, you’ll pay $3,000 more for the same car that a person with great credit would pay. You might think the dealer is screwing you, but they aren’t. In this scenario, the dealer is making the exact same amount of profit either way.
Well, if the dealer’s not screwing you, the bank is, right?
Well, no. Not exactly. It might feel like it at first. But start to think about why the bank of charging a huge fee. Risk, remember? The high interest rate helps, but a large fee helps even more. Regular non-fee charging banks don’t want to finance someone who is a huge risk. It’s simply too risky, and not profitable.
If banks could make money on these types of loans without fees, they would. One bank would start, and the others would have to follow or eventually go out of business.
The moral of the story
Bad credit is not a death sentence. If you need a car, there are ways to get into one. The terms will be painful. You will have to pay more for the same car, and the interest rate will be high. That hurts, I know. But once you start making all your payments on time, the next time you need a car, things will be much more pleasant for you.