What is a Second Chance Loan

A second chance loan is a type of loan associated with subprime lending and borrowers with a tainted credit history. Second chance loans offer a borrower a chance to rebuild their credit history. Although subprime loans might have a typical term-to-maturity (30 years of a mortgage), they are usually intended to be short-term financing vehicles that allow the borrower to repair their credit history to the point where they can refinance into more favorable loan terms. Borrowers must compensate the lender for taking on more risk in lending to them by paying a higher interest rate, thus the incentive for the borrower to refinance as soon as they are able.

Today, second chance loans come packaged under a number of schemes tied to payday loans.

BREAKING DOWN Second Chance Loan

While second chance loans can be of great benefit to borrowers with a tainted credit history, borrowers need to fully understand the risks of such loans. Since many of these loans are intended to be short-term financing vehicles only, they might carry a substantial risk of payment shock if the loan is not able to be refinanced within a borrower's intended time horizon.

Risks of Second Chance Loans

Borrowers need to identify and understand the risks associated with second chance loans such as a 3/27 ARM. A type of adjustable-rate mortgage (ARM) frequently offered to subprime borrowers. These mortgages are designed as short-term financing vehicles that give borrowers time to repair their credit until they can refinance into a mortgage with more favorable terms. 3/27 mortgages have a three-year fixed-interest-rate period after which the interest rate begins to float based on an index plus a margin (known as the fully indexed interest rate).

For example, whether speculating on interest rates or keeping interest cost down due to poor credit, many borrowers took on adjustable rate mortgages near the height of housing boom around 2007-2008. For borrowers using the 3/27 ARM and losing their job during the financial crisis, it was especially challenging. By 2010 and 2011, many of these short-term ARMs were resetting their variable interest rates, but those borrowers without a job were unable to refinance because of no variable income without a job. Fortunately, short-term rates remained low for some time, and a potential ARM rate reset nightmare was largely averted.