Second chance loan

Second chance loan
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Second-chance loans are granted to people who do not have creditworthiness, because they are perceived as high-risk borrowers[1].

Second-chance lending is also often referred to as non-prime, near prime or subprime lending and is addressed to borrowers, who more often fail to meet their obligations than prime borrowers[2].

Borrowers who in the past had problems with timely repayments are usually unable to get a new loan. In this case, the second chance loan option appears. In order to compensate for high risk, the creditor charges higher interest rates or higher fees.

The purpose of a second chance loan is to give the borrowers the opportunity to pay debts on time, which will have a positive effect on their creditworthiness and ultimately allow refinancing of the mortgage loan at a lower interest rate[3].

A second chance loan, like other mortgage loans, is usually planned for a period of 30 years, however in most cases, borrowers try to return them as soon as possible due to the high-interest rates. If the borrower is able to get a loan with a lower interest rate, he converts the second chance loan into a regular loan[4].

Types of Subprime Loans[edit]

Most subprime loans are taken to finance the property, however, some people use it to pay for a car, study period or indebted on a credit card. Lending institutions encourage their clients to use second chance loans, offering them the option to pay back the loan.

Examples of the most-used subprime loans:

  • Interest-Only Loan

As the name suggests, the borrower who will benefit from this form of a subprime loan, at the beginning of its duration receives the option of paying only interest. For borrowers, this is a chance for faster repayment of liabilities, because of these loans are characterized by a low monthly installment. At the moment when the interest back to the loan itself, the monthly installment changes dramatically and is significantly higher. With this loan, creditors often hope that borrowers, after a sudden change in fees, will prefer to sell their homes rather than default on the loan.

  • Adjustable-Rate Loan

The interest rate on this loan at the beginning of its duration is fixed, then it changes into a variable. For a better understanding, it can be assumed that if someone borrows for a period of 20 years at a variable interest rate, the first years, e.g. two, can be fixed at a fixed rate, then gradually or suddenly for the rest of the period. Borrowers, like in the case of interest-only loans, are encouraged by the fact that they can repay this loan at the beginning of its the term, thereby improving its creditworthiness.

  • Fixed-Rate Loan

As the name suggests, it is a loan, at which the interest rate remains at one level throughout its entire duration. It should be noted that the duration of a loan with a fixed interest rate is longer than other loans. As a rule, it is a period of 30 years, but it can also happen that it will be 40-50 years. Borrowers decide on this type of loan because the monthly installment is lower than with other subprime loans, it does not change, but interest rates are usually higher.

  • Dignity Loan

If the borrower decides on this type of loan, he pays an advance of about 10% of the loan value and accepts higher interest rates in the initial loan period. When the borrower makes timely payments from the initial period, the interest rate drops to its base value. It is worth mentioning that the balance of the loan granted will be reduced by the amount paid for interest[5].

Pros and cons of Second Chance Loans[edit]

Second-chance loans are often perceived by people with a contaminated credit history as the only option to improve their credit status and provide financing for goods such as home, car, credit card or education. In fact, subprime loans, because of high interest rates carry high risks[6].

Theoretically, it seems that a fixed interest rate on a subprime loan is very affordable in the first years and with regular repayment, it gives a chance to improve your creditworthiness, which may result in a change in the second chance loan for prime loan.

It is important to note that at the end of the regular interest rate, the interest rate changes based on the index plus margin, in other words, the fully indexed interest rate and the monthly installments may become so high that the borrower's budget will not rise[7].

Second-chance loans consume a very large part of the borrower's monthly income. At the moment when the borrower loses his job or affects him due to a serious illness, a second chance loan will certainly not be a priority on the list of his expenses, which may lose the opportunity to refinance the loan more favorably with an interest-bearing loan.

It should be remembered that second-chance loans have an excessive interest rate, sometimes it is even around 400% per annum. For people who need shelter, transport, often a better solution, and certainly safer is renting instead of using high-risk products[8].

Footnotes[edit]

  1. Schloemer, E., Li, W., Ernst, K., & Keest, K. 2006
  2. Aguiar M. 2012
  3. Goolsbee A. 2007
  4. Schloemer, E., Li, W., Ernst, K., & Keest, K. 2006
  5. Fiorillo S. 2018
  6. Logojan I. 2008
  7. Mehta P. 2008
  8. Bhanu Murthy K.V., Taru Deb A. 2008

References[edit]

Author: Izabela Wilczyńska