What Are Income-Based Loans, and How Do They Work?
Summary
Income-based loans are a type of lending where approval and loan amounts are typically based on your income instead of your credit score. Learn how these loans work, common types and what to watch for.
In this article:
Borrowing money can be stressful if you have less-than-perfect credit, especially when it’s for something important, like an unexpected car repair or another emergency expense. An income-based loan might help you get the funds you need.
While many lenders of personal loans look at several factors that influence your ability to repay the loan, like your credit score and debt-to-income ratio, lenders of income-based loans focus primarily on your income when deciding whether to offer you a loan. Let’s look at how income-based loans typically work, different types of income-based loans and other types of loans that might be a better fit depending on your personal situation.
What is an income-based loan?
As the name suggests, an income-based loan is a type of loan that’s based on your income. The lender will review how steady your income is to help determine whether you’re eligible for a loan, how much you may borrow and the repayment terms.
How do income-based loans work?
When you apply for an income-based loan, the lender typically focuses more on whether you make enough to pay back the loan than they do on other factors like your credit score. A consistent income, for example, may tell the lender that you can afford to pay back your loan.
Eligible income may include wages from a steady job or fees from freelance or contract work. Some lenders also accept Supplemental Security Income (SSI), alimony and investment income.1 You’ll typically need to show proof of income to be approved.
Each type of income-based loan has its own application and approval process, which may include the following:
Income verification
To qualify for an income-based loan, you may need to share documents that prove you have enough money coming in to repay your debt, such as:2
- Pay stubs: Lenders may review your pay stubs to determine your gross pay, which is your income before taxes, and your net pay, which is your income after taxes and any other deductions have been removed.3 Your pay stubs also show whether you get paid on a regular schedule, which may help lenders determine whether you can make your loan payments on time.
- Bank statements: Bank statements give lenders more insight into your overall financial health by showing not only how much money you make, but also how much you save or spend. Some lenders may allow you to link your bank account online, so you don’t need to send physical copies of your bank statements.
- Tax forms: Tax forms like W-2s and 1099s help prove how much you’ve made in the past year. A W-2 shows how much your employer paid you and withheld taxes in a year. A 1099 summarizes non-employment income, like money you made as an independent contractor or freelancer. Some lenders may not require these documents as part of the application process.
- Alternative documents: Depending on what your lender requires, you may be asked to provide other documentation, such as proof of investment income from your 401(k) and IRA accounts, alimony, Social Security benefits, public assistance, regular allowance from someone like a family member, trust payouts, insurance payments or some forms of financial aid for students.
Loan amount
The amount you could borrow with an income-based loan may depend on your net income. Once you’re approved, most lenders distribute your money within a few business days — sometimes even on the same day. You may receive the funds through a check, cash or direct deposit into your bank account.4
Repayment
Depending on the type of loan and lender, you may be able to pay back your loan in installments, or you may have to pay it all back at once as a lump sum on your next payday. In most cases, an income-based loan comes with a higher interest rate, which is the cost of borrowing, and a shorter repayment period than is typically available with a conventional personal loan.5
Types of income-based loans
The two most common types of income-based loans are cash advance apps and payday loans. Both of these typically require proof of income, but don’t require you to authorize a hard credit check.6 Before you commit, it's essential to understand the terms and conditions of each loan.
Cash advance apps
Cash advance apps usually let you borrow between $25 and $750 that must be repaid out of your upcoming paycheck. Cash advance apps typically don’t charge interest, and funds are usually deposited into your account within a few days. There may be additional fees, however, such as for sending you the funds more quickly.7
It’s important to understand that when it’s time to repay the loan, the lender will automatically withdraw the money from your bank account. If you don’t have enough in your bank account on your repayment date, you could be overdrawn. That may lead to overdraft fees and other issues with your bank.
Payday loans
A payday loan is a short-term loan that usually lets you borrow a relatively small amount of cash — typically around $500. Once you receive the funds, you’ll likely have to pay the lender back by your next payday, often within 14 days.
On the surface, payday loans may seem like a solution when you need money in a pinch. However, payday loans come with extremely high interest rates — sometimes with an annual percentage rate (APR) of more than 600% — that may make them very hard to repay. APR is the annual cost of borrowing, including interest and fees. Payday loans are banned or restricted in many states, so it may be difficult to find one with terms that work for you.8
Pros and cons of income-based loans
Just like all loans, income-based loans come with advantages and disadvantages, including:
Pros
Fast funding: Typically, lenders will distribute your funds within a few days. Depending on the loan type and when you apply, you might even receive the money the same day.9
Easier qualification: Since income-based loans are based on your income, you may qualify for them with less-than-perfect credit.10
Cons
Higher interest rates: Most income-based loans have much higher interest rates than traditional financing options, like conventional personal loans. A high interest rate may make the loan more expensive in the long run and make it harder to pay back what you owe.11
Additional fees: Some income-based loans, like payday loans, may charge you fees in addition to the high interest rate.
Smaller borrowing amounts: Income-based loans typically let you borrow just a few hundred dollars, so you may not be able to use them for significant expenses. If you need to buy a car or pay a major medical bill, you will need to look elsewhere.12
Potential credit issues: If you’re unable to repay an income-based loan on time, and the lender reports your default to the credit bureaus, your credit score may decrease. A lower credit score could limit the types of loans you may be able to qualify for in the future.13
Alternatives to income-based loans
Before you take out a purely income-based loan, it’s a good idea to explore alternative options, especially if you have less-than-perfect credit. You typically still need to provide proof of income for most of these alternatives, but lenders consider other factors to determine your eligibility.
Secured personal loan
Secured personal loans are backed by collateral, something of value that you possess, like your car. A secured loan has more flexible approval standards than some other loans. You may qualify for a better interest rate or larger borrowing amount on a secured loan than you might with an unsecured loan, especially if you have a below average credit score. Approval for an unsecured loan relies more on your credit score, credit history and income.14 Keep in mind that if you default or fall behind on secured loan payments, the lender may repossess your collateral.
Lenders like OneMain offer both secured and unsecured personal loans with fixed interest rates and predictable monthly payments. A personal loan can get you funds quickly, too. At OneMain, for instance, you could get the money you need as soon as one hour after loan signing, with a repayment plan that works for your budget.
Unsecured personal loan
If you’d rather not back your loan with collateral, you may consider an unsecured personal loan. While unsecured loans may have stricter credit requirements than secured loans, some lenders, like OneMain, take your whole financial picture into consideration to determine your eligibility — not just your credit score. OneMain works with a range of credit scores to help you find the loan that’s right for you. Prequalification lets you consider your options without hurting your credit score, so you can check for prequalified offers for unsecured loans before you apply.
Credit-builder loan
A credit-builder loan lets you build credit and save money at the same time. With a credit-builder loan, you typically don’t receive the money until you’ve repaid it. The lender holds the loan amount in a secure account while you make fixed monthly payments. When the loan term is up, if the requirements of the loan have been met, the lender will give you the money. Think of it like a piggy bank that helps you build your credit history.
Credit-builder loans may be hard to find at a traditional bank. You might be able to get one from a smaller lender, like a credit union. If you make your monthly payments on time and the lender reports them to the credit bureaus, your credit score could improve.15
Cosigned loan
If you’re having a hard time qualifying for a loan because you have less-than-perfect credit, you could consider applying with a cosigner. A cosigner doesn’t have access to the loan funds. Instead, they act as a guarantor who agrees to take on the legal responsibility of repaying the loan. If your cosigner has a stronger credit history and credit score than you do, the lender may be more likely to approve your application.
Cosigners are often relatives or close friends, but requirements may vary depending on the lender’s rules. Choose your cosigner wisely because you’ll need to maintain a good relationship with them throughout the loan period. Make sure you choose someone who is both approved by the lender and who you trust to have honest conversations with about money.16
Joint personal loan
Another option is to apply for a loan with a co-borrower who has a higher credit score. A co-borrower is different from a cosigner in a few important ways: They have a legal right to use the loan funds and share equal responsibility for making payments.17
As with a cosigner, a co-borrower should be someone you trust with money, can maintain a good relationship with throughout the loan period and who meets the lender’s requirements.
Loan from friends or family
A loan from a friend or family member might be an option if you know someone willing to help when you have an emergency expense or need some extra cash. Borrowing from someone you know may help you avoid a credit check or high interest rates.
However, loans from friends or family can strain a relationship. If you borrow from a loved one, take the loan seriously. Agree on repayment terms that work for both of you, write them down and pay your loved one back as promised.
Weigh the cost before you borrow
Income-based loans may offer borrowing options for people who might not qualify for traditional loans or lines of credit. However, like all loans, they come with risks, particularly due to their high interest rates and short repayment terms, so they may not be right for everyone.
Before you take out an income-based loan, read the agreement carefully to understand the terms and avoid borrowing more than you can afford. Also, remember to compare different financing options before you make a final decision. Take the time to figure out which option is right for you and your financial future.
Sources
1, 2 https://www.experian.com/blogs/ask-experian/what-counts-as-income-on-credit-application/
3 https://www.nerdwallet.com/article/finance/take-home-income
4 https://www.cnbc.com/select/what-is-a-personal-loan/
5 https://consumer.ftc.gov/articles/what-know-about-payday-and-car-title-loans
6 https://www.forbes.com/advisor/personal-loans/cash-advance-vs-payday-loan/
7 https://www.debt.org/credit/loans/cash-advances/apps/
8,9, 10,11,12 https://www.bankrate.com/loans/personal-loans/payday-loans/
13 https://www.bankrate.com/loans/personal-loans/how-open-personal-loan-affects-credit/
14 https://www.equifax.com/personal/education/personal-finance/articles/-/learn/what-is-a-secured-loan/
15 https://www.nerdwallet.com/article/loans/personal-loans/what-is-credit-builder-loan
16 https://consumer.ftc.gov/articles/cosigning-loan-faqs
17 https://www.experian.com/blogs/ask-experian/coborrower-vs-cosigner/
This article is for general education and informational purposes, without any express or implied warranty of any kind, including warranties of accuracy, completeness, or fitness for any purpose and is not intended to be and does not constitute financial, legal, tax, or any other advice. Parties (other than sponsored partners of OneMain Financial (OMF)) referenced in the article are not sponsors of, do not endorse, and are not otherwise affiliated with OMF.
