August 26, 2024

What Are Income-Based Loans and How Do They Work?

There are many ways to borrow money — but the challenge with traditional loans is they require a credit check or collateral. And for many people, they simply aren’t accessible.

That's where income-based loans come in. They’re a type of personal loan based on income, not credit. And they’re especially attractive to people looking for low-income loans who might not otherwise be able to land one.

Here’s a guide to what income-based loans are, how they work, and possible alternatives.

What are income-based loans, and how do they work?

When you apply for a loan with a financial institution, it usually does a credit check or asks you to provide an asset as collateral. That’s because lending is a risk, and institutions want to make sure they can trust you to give them the money back.

Income-based loans operate through a different model. Instead, your employment income affects the application, loan amount, and interest rates — showing lenders how much you make is just another way of telling them you’re able to pay the loan back. This means if you have a bad credit score or aren’t in a good financial position, you can still take out a loan.

Loans based on employment work like traditional loans, but with a slightly different application process. The lender asks questions about a person's income, lifestyle, family size, and related expenses to gauge if they can repay the requested amount.

The loan agreement usually comes with higher interest rates than other borrowing products to compensate the lender for the risk of not receiving repayment. A person with minimal expenses and a good, consistent income is likely to receive a larger loan than someone with many expenses and a lower, less consistent income.

The pros and cons of income-based loans

Personal loans based on income only have quite a few pros:

Accessibility with poor credit. People with little to no credit or assets to post as collateral may find income-based loans their best options for borrowing money. These loans don't significantly consider a person's credit score, if at all, and don't require any assets for eligibility.
Versatility. Money from income-based loans can be helpful in any situation. Unlike mortgages, car loans, or other purchase-specific borrowing products, income-based loans don't have any restrictions on what you can use the money for.
Lower monthly payments. Because these loans are tied to your income, they often include lower monthly payments than traditional borrowing products. While there may be higher interest rates, the lower overall payments are a priority for some.
No income threshold for eligibility. Some loans and borrowing products require a specific income level to qualify. But depending on the provider, there’s no threshold for Income-based loans. It isn’t about how much money you make, but the fact that you have a steady income in the first place. Just remember that depending on your earnings, the borrowing amount you're seeking may not always be possible.

Income-based loans also have their cons. Here are some things to consider that may dissuade you from getting an income-based loan:

Longer borrowing periods. Since these loans often come with smaller monthly payments, the borrowing periods are typically longer. That means you might end up repaying much more than the original amount due to compounding interest.
Higher interest rates. Speaking of interest, income-based loans often have some of the highest interest rates of any borrowing product. Interest is the money you pay the lender for taking on the risk of loaning out money. The more interest a lender charges, the riskier they consider a loan to be. Since income-based loans don't require any collateral or consider your credit score, higher interest rates are how lenders hedge risk.
Similar consequences for lack of repayment. While an income-based loan may not consider your credit score when determining eligibility, lack of repayment can lower your score.
Risk of predatory lenders. No matter when or why you need to borrow money, keep an eye out for predatory lenders. These are people or businesses who may offer a loan, but with illegally high interest rates or other questionable terms. Do your research and due diligence to make sure your lender’s legit.

How to apply for an income-based loan

Applying for an income-based loan is similar to applying for other borrowing products. Here are five steps to take:

1. Select a lender. Once you decide to apply for a loan, the first step is to determine which lender to borrow from. Factors you may consider include the interest rate, income-based loan repayment terms, and borrowing amount. This step requires a bit of research, so take your time to find the best deal.

2. See if you prequalify. After selecting a lender, visit its website or reach out to see if you can prequalify. Prequalifying typically means providing basic details about who you are, how much you earn, and anything relevant to the lender to learn what hypothetical terms might be. This process usually happens via a web form, where you get a result in seconds.

3. Gather the necessary documentation. If you decide to proceed with the loan application, provide specific documentation as requested by the lender. Information like proof of income and identification is almost a guarantee.

4. Be prepared to answer follow-up questions. The lender may have some follow-up questions about your application and documents. It's normal for it to want to clarify a few things or request additional information. Promptly provide the details to avoid delaying the application.

5. Read your loan agreement. The final step to accessing your loan is to review and sign off on the loan agreement. Make sure everything on the document is correct, including your personal information and loan details. Read through it carefully. If there's anything wrong or something doesn't look right, ask for clarification or an adjustment. Otherwise, sign off and complete the process.

4 alternatives to income-based loans

Due to the higher interest rates that come with an income-based loan, you may be curious about the other options out there for borrowing money. Here are four alternatives to income-based loans:

1. Personal loans

Personal loans are a popular borrowing option for people seeking flexible lending arrangements. They’re versatile borrowing options, offering fixed interest rates and predictable monthly payments. While getting a personal loan typically requires a credit check, it’s still a reasonably affordable option for financing larger purchases and covering unexpected costs.

2. Credit cards

Credit cards are the ultimate flexible borrowing option. They can be useful almost anywhere, making them convenient for covering short-term borrowing needs. Given that borrowers typically already have a credit card, using one to cover necessary expenses is quick and accessible. Just make sure you can pay the bill within a reasonable timeframe to avoid high interest rates.

3. Home equity lines of credit

Home equity lines of credit, or HELOCs, are loans you can take out against your home. Since there’s a house as collateral, interest rates are lower — but the risk is higher because you lose the property if you don’t pay the lender back.

4. Peer-to-peer loans

Whether between two strangers via an app or with a close friend, peer-to-peer loans are often the lowest-cost way to borrow money. They’re particularly good if you’re avoiding a credit check or can’t provide collateral. Plus, peer-to-peer loan applications are usually accepted much faster than traditional loans.

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Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.