What is a Second Chance Loan?

A second chance loan is a type of loan intended for borrowers with a poor credit history, who would most likely be unable to qualify for traditional financing. As such, it is considered a form of subprime lending. A second chance loan generally charges a significantly higher interest rate than would be available to borrowers who are considered less of a credit risk.

How a Second Chance Loan Works

Second chance loans are often offered by lenders that specialize in the subprime market. Like many other subprime loans, a second chance loan may have a typical term-to-maturity (such as a 30-year mortgage), but it is usually meant to be used as a short-term financing vehicle. Borrowers can obtain money now and – by making regular, on-time payments – begin to repair their credit history. At that point, they may be able to obtain a new loan with more favorable terms, allowing them to pay off the second chance loan. The high interest rate on a second chance loan gives borrowers an incentive to refinance as soon as they are able to.

Another kind of second chance loan comes with a very short term, sometimes as little as a week or two. Rather than being paid off over time, this loan variant must be paid in full at the end of that term. These loans tend to be for smaller amounts, such as $500, and are often offered by payday lenders, who specialize in short term, high interest loans, timed to coincide with the borrower's next pay check.

Second chance loans can help borrowers with poor credit, but because of their high interest rates, they should be paid off as quickly as possible.

Pros and Cons of Second Chance Loans

While second chance loans can help borrowers with a tainted credit history rebuild their credit – and may be the only option if they need to borrow money – these loans carry substantial risks.

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 an adjustable-rate mortgage (ARM) known as a 3/27 ARM. In theory, these mortgages, which have a fixed interest rate for the first three years, allow borrowers enough time to repair their credit and then refinance. The fixed rate also gives the borrower the comfort of predictable monthly payments for those first three years.

However, when that period ends, the interest rate begins to float based on an index plus a margin (known as the fully indexed interest rate), and payments may become unaffordable. What's more, if the borrower has lost a job or suffered other financial reverses in the meantime, refinancing to a better loan at more favorable rates may be impossible.

Short-term second chance loans from payday lenders have their own downsides. One is their often-exorbitant interest rates. As the federal Consumer Financial Protection Bureau points out on its website, "A typical two-week payday loan with a $15 per $100 fee equates to an annual percentage rate (APR) of almost 400 percent."

Before borrowers even consider a second chance loan they should make certain that they don't qualify for traditional financing from a bank or other lender, which is usually less expensive and less risky.