If you have negative credit history and are trying to improve your credit, then a credit builder loan can be a good option. However, before you apply for one, you need to understand both how they work and who they are best for.
Improving credit can take years while you wait for negative remarks to fall off your credit report. But with a credit builder loan, instead of taking a passive approach waiting for updates on your report, you can take an active approach that will help build your credit.
So, let’s take a closer look at credit builder loans. Specifically, how they work and how they can help you improve your credit score.
What is a credit builder loan?
A credit builder loan is an installment loan that serves the purpose of helping you build positive credit history. If you've struggled with loan payments and credit cards in the past, you can make bad credit better.
It allows you to take out a loan where all the loan funds are deposited into an FDIC-insured bank account. The funds stay in the account for the duration of the loan, so you won't have access to them until you pay off your loan.
These essentially act as collateral. Once the loan is paid off, you'll be granted access to the funds.
When you take out this type of loan, it is typically for a short-term period, somewhere between a 6 month credit builder loan and a two-year one.
The loan is designed to be less risky for the lender because they hold onto the loan funds as you make regular payments. It allows the lender to reduce any potential loss should you prove unable to make your payments.
When you are trying to build credit, it can be difficult to find a lender that is willing to work with you. That’s because a non-existent or low credit score may indicate to a lender that lending money to you is a risky undertaking based on your past financial decisions.
Without the opportunity to prove that you are ready and willing to handle a loan responsibly, lenders may never realize that you are a good borrower to work with.
An option like this can help you out of this cycle. Instead of waiting for new reports to be added or past mistakes to fall off your credit report, you can actively pursue a better credit score with this type of loan.
Details of how a credit builder loan works
With credit builder accounts, throughout the loan term, you’ll make monthly installment payments. As mentioned, at the end of the term, the lender will give you the funds that were initially stashed in a bank account.
It is important to note that you will only receive these funds with repayment of the loan. If you default for any reason, the lender will have the right to keep the original loan amount in the bank account.
As you pay off the loan, it might feel like you are putting money away in savings. And that's because you are! When you get the funds at the end of the loan term, you’ll enjoy the lump sum payment of your loan amount.
Overall, a credit builder loan offers two benefits. First, you’ll earn a credit boost if you make your payments on schedule. Second, you’ll receive a boost to your savings at the end of the loan term.
There is also such a thing as an unsecured credit builder loan, which is similar except that you receive the money upfront. However, an unsecured credit builder loan also lets you build credit. But we will focus on the regular credit builder loan for this article.
Can a credit builder loan help your credit?
A credit builder loan is reported to the credit bureaus, which keep track of your credit history. In the US, three major credit bureaus keep track of your history: Equifax, Transunion, and Experian. The reports held by these bureaus form the base of your credit score.
One of the biggest factors that affect your credit score is whether or not you make on-time payments to your loans. With a clean payment history, your credit score will start to rise.
With that, a credit builder loan can truly help you improve your credit score. But you’ll need to make on-time payments throughout the course of the loan.
If you aren’t able to make on-time payments to your loan, then you might end up hurting your credit score.
Why build good credit?
Why does all of this matter? Because having good credit gives you way more options!
With good credit, it's easier to buy assets like a home. You'll also likely get a lower annual percentage rate on credit cards and have the ability to get unsecured credit cards.
These things matter because a savings account isn't always enough. Eventually, you may want a credit card account and the ability to take out a loan.
How much do credit builder loans cost?
Like all loans, credit builder loans have several costs associated with them. Keep these in mind as you consider your options.
Interest payments
As you make payments to your loan, part of your payment will cover the interest of the loan. Which is money that you won’t get back at the end of the loan term.
Fees
Most credit builder loans will involve a startup fee. But some will also include other fees along the way. As you consider your different loan options, make sure to take these fees into account.
APR charges
The APR on a credit builder loan will include the total interest rate plus the effect of any fees. Keep an eye on this number as you shop around for credit builder loans.
Where to get a credit builder loan
Although there are many companies, below are some places to consider for credit builder accounts.
Take some time to shop around for the best fit for your situation. As with any loan, take a minute to compare the APRs and fees attached to each loan.
Additionally, check out customer reviews to make sure that you feel comfortable with the lender. Once you have found the best option for you, then take action!
A credit union or community bank
Many credit unions and community banks offer loan options that can help build and improve your credit. These options also include credit builder loans. They also typically have the most favorable rates.
Community Development Financial Institutions (CDFI)
If you are unable to get a credit builder loan from a credit-builder or community bank, a Community Development Financial Institutions (CDFI) is worth a try.
These institutions focus on financial inclusion by supporting the under-banked and those left out of traditional banking services.
Online lenders
Online lenders like Self offer a variety of credit builder loans. You can choose your loan terms e.g. 12 or 24 months and also your monthly payment plan. The size and length of the loan will depend on your credit-building goals and your budget.
Who should use a credit builder loan?
A credit builder loan is a great way to improve your credit score. If you find that past financial behavior has left you with a score you don't want, you can make progress. With a good credit score, you have the opportunity to secure attractive financing for a variety of loans.
For example, you may want to purchase your first home in the future, a good score can help to make that dream an affordable reality.
If you want to improve your credit and are willing and able to make on-time payments, then this type of loan might be a good option for you. You could even start short term with a 6 month credit builder loan if you're unsure about committing to a longer time.
Before you get started, take a look at your budget. Make sure that you are able to support on-time payments before moving forward.
Who shouldn’t use a credit builder loan?
Although there are many benefits to a credit builder loan, there can be negative consequences. If you aren’t in a position to make on-time payments, then you might end up hurting your credit.
Even late payments on something as short-term as a 6 month credit builder loan can hurt your credit score.
Beyond the possibility of hurting your credit score, you may not need to consider a credit builder option if you don’t want to pursue large purchases through financing in the future.
If you plan to make all of your large purchases in cash, then you might not need the boost of a good credit score. However, making large purchases in cash can be extremely difficult for most people.
Think about the real possibility of being able to purchase a home or your next car in cash before disregarding this opportunity. After all, it never hurts to have a good score to support your finances.
Alternative options to build credit
Maybe you've decided that a credit builder loan isn't what's best for you. But you still want to build up your credit. Here are some good alternatives.
Good credit practices
If you would like to improve your score, you need to commit to good credit practices. For example, don't make late payments. You could also check your FICO score and credit score to see what the actual number is and then keep track of it periodically.
When you're able to, try to obtain a higher credit limit, as this helps your overall percentage of available credit to go up, thus helping your score.
You might also ask a primary cardholder if you can become an authorized user on their credit account, which can potentially boost your score.
Do what you can to obtain a better score and continue to do this even when your score improves.
Secured credit card
A secured card lets you build credit and use the card as a credit card, but with less risk. You put down a security deposit and then can use the card as you would a regular one. If you handle it well, you could improve your credit score.
A credit builder loan could be a good idea for you to build credit!
Credit builder loans can be a good financial tool. But only if you are able to keep up with the payments. Otherwise, you’ll end up back where you started with bad (and potentially worse) credit.
With a good credit score, you can enjoy the opportunities for better financing for many major purchases. If you want to improve your credit score and have the ability to make on-time payments, then move forward today!
With commitment and patience, you'll find that leveraging this approach can be worth your time.
Clever Girl Finance offers a lot more information about credit cards and good money habits that you can check out, or try one of our free financial courses.