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You could say that a credit-builder loan is like manna from heaven for people with poor credit or little or no credit history. Why?
It’s because this loan will help them build credit. Then, if they can get a good credit score later, it will be easier to get a credit card, and they are more likely to be able to negotiate for a better interest rate.
Credit-builder loans are unique because they do not require good credit for approval, unlike credit cards or personal loans for good credit. However, the lender will require you to have much income every month such that you can afford the monthly payments.
When you borrow money, the lender will hold the amount you borrowed in a bank account while you keep making regular payments. Then, they will report your on-time payments to the three major credit bureaus: Equifax, Experian, and TransUnion. Since they calculate credit scores from the data from your credit reports, making on-time payments will have a significant positive impact on your score.
In this chart compiled with LendingTree customer data, you can see that those with a 720+ credit score pay an average of 7.63%. At the other end of the scale, for those with a poor credit rating of less than 560, the rate shoots up to an eye-watering 113%.
What Is A Credit Builder Loan?
Perhaps, to many borrowers, patience is the most challenging element to build good credit, whether from the ground up or repairing a bad credit history. You’ll need ample time to show lenders that you are a trustworthy borrower who makes on-time payments regularly.
A credit builder loan could be the best way to jump-start your journey to good credit history. This is how it works:
- A financial company, such as a credit union that typically issues credit builder loans, will first deposit a small amount of money into a secure savings account for the borrower.
- Once the money is in the account, the borrower begins paying back the money in small monthly installments over an agreed period. Of course, the monthly payment will have an interest component.
- The bank releases the money to the borrower at the end of the loan, which usually ranges from six months to two years, provided the borrower has paid off the loan. The borrower will receive the money in a lump sum plus any interest earned (if the lender pays interest).
A significant benefit will accrue to borrowers who can pay their monthly obligations on time. Lenders will report the payments to credit reporting companies, and this data will go into the borrowers’ respective credit histories. Eventually, they will begin to build a solid credit report because of this information.
How a Credit Builder Loan Boosts Your Credit?
A credit builder loan helps individuals build their credit by allowing them to show their creditworthiness through small monthly payments.
As they make their monthly payments on time, the lenders will report these regular loan payments to the credit reporting agencies. By doing this, the borrowers’ credit history will show that they can make consistent, on-time loan payments until they’ve fully paid off the loan according to its terms.
Next, let’s see what it does to credit scores. After a borrower has started building a credit history and established trade lines in use, he begins to develop his credit score.
FICO and VantageScore are the most popular measures, ranging from 300 to 850. Of course, any borrower would want to target a higher score because it shows a long and positive history of responsibly using credit facilities.
When building your credit score, you must start from the low end. But after a year or so of borrowing and patiently repaying your loans, your numbers will begin to rise quickly. The two most critical scoring factors are your payment history and debt utilization ratio (amount of actual debt over the amount of credit you have).
The length of your credit history, the types of credit you use, and how often you apply for new credit all play a role in your score. While there’s no quick fix—since you can’t rush the terms of a loan—you can manage multiple loans at once to demonstrate your ability to handle different types of credit responsibly.
Apply Only For Credit You Can Get
A word of caution: apply only for credit that you’re sure you can get because hard inquiries resulting from your loan application will pull your score down.
Credit builder loans are characteristically small and range from $500 to $2,000 so a borrower could easily afford the small monthly payments.
However, interest rates will still vary from lender to lender so it’s always good to do some scouting to get the most favorable rate. You might find rates from as low as 5% per year all the way up to 16% p.a. at different banks.
Applying for a credit builder loan is quite easy. A borrower can just simply go to a local lender’s branch to apply or file an application online. Since the lender won’t release the actual funds to the borrower until he pays off the loan in full, most borrowers can qualify for a credit builder loan in a flash.
Types of Credit Builder Loans
Credit builder loans fall under two types: pure credit builder loans and share-secured loans.
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Pure Credit Builder Loans
Pure credit builder loans achieve two critical objectives for the borrower. First, it helps a borrower put up a savings account while building up credit simultaneously. The lender puts the entire loan proceeds in a savings account under the borrower’s name, which stays frozen until the borrower pays off the loan.
- The borrower does not need to make an initial deposit to the bank, but he has to make the monthly payments until the loan is paid off.
- Afterward, the money goes to the borrower, who can use it as a secured credit card deposit. But, more importantly, the loan history goes into his credit report and becomes an excellent entry to help improve his credit score.
This strategy has many other uses, such as building savings for a down payment for a car. In addition, adding good entries to your credit history will improve your credit score over time, and once you have an ideal score, you could haggle for a lower interest rate on an auto loan.
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Share Secured Loans
In a share-secured loan, the lender uses a savings account as collateral for the loan. The borrower has to deposit a sum of money into a savings account. Then, the bank will freeze the funds in the account and unfreeze them commensurately to the borrower's loan payments.
Why would someone go through all this trouble? This scheme is perfect if a person wants to improve their credit mix, which is one of the factors in determining a credit score.
Although it would result only in a modest increase of around 10 points, it is important for someone whose score only needs a few points to move from “fair” to “good.” For them, the slight difference between the interest on the deposit and the interest on the loan is worth going through.
Credit bureaus pay attention to revolving credit (like credit cards) and installment credits (auto loans, mortgages, and personal loans such as a share secured loan). If a borrower only has credit cards on his credit history, a share-secured loan would help a little. Take note that it will only be a slight uptick because share-secured loans are usually small short-term loans.
How Can You Get a Loan to Build Credit
Credit-builder loans can be a simple way to build or rebuild your credit, though they’re not the most common option. It might take some effort to find a lender that offers them, but since they’re a secure and effective way to boost your credit score, it’s worth putting in the work to track one down.
You may look for a credit-builder loan at the following:
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Credit Unions
Credit unions offer the same line of products and services like a traditional bank but they are a nonprofit entity. Plus, they offer other services – including credit-builder loans. They will also keep the money they lend in an account until the borrower completes the term which is anywhere from 12 to 24 months.
Their interest rates are slightly lower than with other unsecured loans, and many credit unions put the funds in an interest-earning savings account, so that helps a little.
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Local Banks
Most national banks do not offer credit-builder loans and will often suggest that you get a credit card instead. You might have better luck with a local bank where you can get a personal loan that you secure by your funds until the end of your loan term.
At the proper time, you can choose to withdraw the total amount you’ve saved or keep them in the bank as a nest egg. It all depends on what you think will be of most financial benefit to you and your situation.
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Online Lenders
The good thing about online lenders is that you can rebuild your credit without having to actually leave your house. Businesses such as SelfLender work through banks and give out small loans that borrowers can repay over a year.
You need a certificate of deposit to secure your loan until it’s paid off while in the meantime, your lender reports your payment activities to the three major credit bureaus.
Alternatives to Credit Builder Loans
There are other ways to establish a good credit score aside from getting a credit-builder loan. Here are some of them:
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Apply For a Secured Credit Card
A secured credit card works the same way as a credit-builder loan in building or rebuilding credit history. The application process is practically the same, except that a secured credit card issuer will require a deposit of around $50 to $300 into a separate account.
The bank will issue the borrower a line of credit, usually equal to the amount in a deposit. This way, the borrower can build a credit history without exposing the lender to risk.
Some credit card companies will allow their borrowers to “graduate” and level up to a traditional credit card after they’ve proven they can meet their monthly payments religiously.
Lenders will report your payment history to credit reporting bureaus and, as an added service, will offer autopay, online payments, and alert notifications to make sure you don’t forget to pay on time.
These types of cards are not always free. Some will require that cardholders pay an annual fee and agree to a high APR that can sometimes go as high as 25%.
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Try to Get an Unsecured Personal Loan
There are unsecured personal loans that borrowers can easily qualify for to help them build credit. These are small to big loans, ranging from $2,000 to $50,000 that lenders make available to borrowers with lower credit scores.
The lender will release the money to the borrower upfront. If the borrower has the proper financial discipline, he can use the same funds to repay the loan since his purpose is primarily to build credit and not to source for extra spending money.
This path to building credit is a little risky and a bit costly. Many lenders of unsecured personal loans charge origination fees and interest rates that can run up to 36% per year. From that point of view, it’s an expensive way for an individual to build credit.
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Joint Account Holder or Authorized User
Consider asking a family member to add you to their credit card account as a joint account holder / authorized user.
In a joint account arrangement, the responsibility for making payments would be on each account holder so that any late payments would negatively affect each account holder’s history.
Authorized users, on the other hand, are not responsible for making payments but they have access to use the credit card facility. Although both options can be a way to build credit, not all card issuers report authorized user accounts to the credit reporting agencies. Be sure to find out about this before you ask them to add you to their account.
As in any other type of credit, choosing any of these options means you have to pay back your debts on time through monthly or bimonthly repayments. Remember that any late payments or missed payments will have a negative impact on your score.
One more important thing: just be sure you can afford to take the extra debt before you borrow. Going into it without doing so could bury you in debt you must consolidate later, wreck your budget, and bring your credit to a worse situation than before.
Should You Try a Credit Builder Loan?
Yes, we can all agree that a credit-builder loan is a good way to build your credit – but it’s crucial that you are certain that financially, you can afford it. Compute how the monthly payments will impact your budget, if at all. It’s never wise to get any loan that would turn your budget upside-down because it would normally cause you to fall behind on your other bills and debts. This would, in turn, hurt your credit score instead of making it better.
Remember that in many cases, you’ll be advancing your own money and you may not get it back for several months or even a couple of years. And that would depend on the size of the loan and how much your monthly payment would be.
Remember too, that you will be paying interest that goes to the lender and does not go back to you at the end of the loan term. Using this type of loan will cost you money. It would be a bonus if you can find a lender that will refund the interest charges if you make all your payments within their due dates.
