The primary reason a bad-credit borrower pays higher finance charges is the risk of defaulting on the car loan. The lender that finances the car also has staffing costs to consider, and a bad credit loan may require the use of a collector. There are ways that a borrower with bad credit can possibly reduce the finance charges, such as adding a cosigner to the loan or renegotiating the purchase price with the dealer.
A dealership uses an outside lender for financing and does not actually lend money for the purchase of a car. The lender reviews the credit application you fill out at the dealership to determine if you qualify for a car loan. When you have bad credit, the lender has to rate the loan as a potential default risk. If you receive an approval on your loan, the lender offsets the risk by charging you a higher interest rate. The higher rate means you'll pay more finance charges on your loan than a borrower with good credit.
Lender Collection Costs
A lender has to pay employees to service a portfolio of car loans. Some of these employees are collectors who monitor the payments on all of the loans. When you do not pay your loan on time, the collector has to find out why and resolve the problem. A lender will assume that when you already have bad credit, you will eventually require a collector to work on your loan account. A portion of the higher finance charges you pay as a bad credit borrower goes toward the salaries of the lender's collection staff.
Reduce the Risk to the Lender
There are ways you can reduce the lender's risk to possibly receive a lower loan interest rate. If you have bad credit, by applying for a car loan with a cosigner you reduce the default risk to the lender. A cosigner is a relative or close associate who has good credit and is willing to sign with you on the loan. Apply for the loan at the dealership on your own first. Add a cosigner to your application if your interest rate is high or if the lender denies your loan request altogether. The lender will review your cosigner's application to determine if the loan qualifies for a lower interest rate
Negotiate With the Car Dealer
Another way to possibly reduce your overall purchase cost is by negotiating with the car dealer. For example, assume you and the dealer already agree on the purchase price for the car and you do not have a cosigner. You then apply for the loan and because of your bad credit, you receive a high interest rate. Your next step is to talk again with the dealer to renegotiate the purchase price of the car. If the dealer is willing to lower your purchase price, you will not have to borrow as much and will pay lower loan finance charges.
Jeff Todd, a former futures trader and banking and finance professional, started his writing career in 1997, producing content for The Motley Fool. He has since written for several trading websites and online media companies. He attended Wesley College, and received banking certificates from Louisiana State University and the University of Oklahoma.