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A credit builder loan is a type of loan that helps you rebuild poor credit or establish credit for the first time. Its sole purpose is to help you raise your credit score, and having a good credit score—or even any score at all—isn’t required to apply for one.
Taking out a credit builder loan means borrowing a specific sum of money—but you don’t have access to the funds. Instead, it gets deposited into a savings account that you can’t access until your loan term ends and you’ve made all of your payments.
How do credit builder loans work?
A common issue people face when trying to improve their credit is the inability to qualify for a loan or a credit card—an essential component to building credit. If you carry poor credit, lenders are less inclined to lend you money. But if you can’t get approved by any lenders, you never get the chance to build up your credit.
A credit builder loan is a low-risk way for lenders to loan money to those with poor credit, while also providing people the chance to build a strong credit history.
A credit builder loan functions in the opposite way of a traditional loan. Instead of gaining immediate access to funds that are repaid later, the money you borrow gets set aside in a secured savings account while you make monthly payments toward the balance. This allows you to make consistent, on-time payments on the loan that will show up on your credit report, thus improving your credit score.
How can credit builder loans raise my credit score?
As with any other type of loan, responsible credit usage is key to improving your credit score. Lenders will report the payments you make on a credit builder loan to at least one of the major credit bureaus, who will then put this information in your credit report.
If you make your payments on time for the duration of the loan, you show that you’re a reliable borrower. This is reflected on your credit report, which is what your credit score is based on. Keep in mind that since this isn’t a traditional loan, making your payments early won’t have any advantages over just paying your monthly balance on the agreed-upon schedule.
While you might start off with a low credit score, a year or two of responsible borrowing with this kind of loan will help those numbers rise. Payment history is a critical credit scoring factor—it accounts for 35 percent of your FICO® score. By responsibly managing a credit builder loan, you have the chance to build a positive payment history.
How much does it cost?
Costs will always vary by lender, so it’s important to shop around and compare options to find the best rate. Here are some of the common costs to expect with a credit builder loan:
- Administrative fees: An administrative fee of $8 – $15 is usually required before you can qualify for the loan.
- Interest rates: Credit builder loans come with interest, and the rate will vary depending on your lender and your unique credit history. Typical interest costs are usually between six and 16 percent.
- Payments: The cost of your monthly payments depends on how much you choose to borrow. Most loan amounts might be anywhere from $300 to $1,000—choose an amount
Is a credit builder loan worth it?
The answer to this question will always depend on your unique financial situation. A credit builder loan can be a helpful tool if you need to build your credit from the ground up or improve a poor credit score. Here are some things to consider that might indicate a credit builder loan wouldn’t be your best option for building credit:
- You need access to funds right away: Remember that a credit builder loan works in the reverse way of a traditional loan. Instead of using the loan to access borrowed funds, you’ll be contributing your funds to a secured savings account that you can’t access until the loan term is up. If you’re looking to take out a loan because you need immediate funding, a credit builder loan won’t help you.
- You don’t have enough money to dedicate to a credit builder loan: A credit builder loan will only improve your credit score if you make your payments consistently and on time for the duration of the loan. If you have to stretch your budget in order to fund a credit builder loan, you risk missing a payment and ultimately damaging your score. Make sure you can afford to contribute to this type of loan before committing to it.
Where to get a credit builder loan
Credit builder loans are offered by many financial institutions, including credit unions and local banks. You usually won’t find them at big banks, as credit builder loans aren’t profitable enough and are rarely advertised. Check these places instead:
Credit unions: To get a loan from a credit union, you need to become a member. Common membership requirements include living in the area where the credit union is based or working for a certain company. You might also have to pay a membership fee.
Community banks: Smaller, local banks usually offer credit builder loans as well. You can search for local banks in your area and call them to inquire about what types of loans they provide.
Online lenders: It’s possible to find online lenders who offer credit builder loans, and finance companies are becoming aware of the benefits of offering them.
Wherever you decide to go, make sure their lender reports payments to at least one of the major credit bureaus: Experian®, Equifax® and TransUnion®. Ideally, they report to all three—this is necessary in order to have your payment history reflected on your credit report.
How else can I increase my credit score?
A credit builder loan isn’t the only way to build credit. Even if you have a poor credit score, there are other options to improve your credit standing.
Secured credit cards
This is a great option for poor credit carriers because approval is basically guaranteed. The only requirement is a cash deposit, which also becomes your credit limit. Your activity on a secured credit card gets reported to the credit bureaus just like with a credit builder loan, so you have the opportunity to demonstrate a positive repayment history and boost your credit score.
Become an authorized user
If you can’t qualify for a credit card of your own, a low-risk way to build credit is to become an authorized user on someone else’s credit card. This allows you to use the credit card owner’s line of credit, but the card owner is the only one responsible for payment. If you have a friend or family member who’s willing to add you to their card—and they have responsible credit usage habits—their payments and activity will appear on both of your credit reports, giving you the chance to raise your score.
Secured personal loan
A secured personal loan requires you to put up collateral in order to borrow funds. This makes it less risky for lenders to loan to you, since they can seize your collateral if you don’t make your payments as scheduled. While this is an option to build up your credit, the possibility of losing your collateral makes it riskier.
Unsecured personal loan
This type of loan isn’t backed by collateral, but interest rates are typically much higher, making this a more expensive way to build your credit. They’re also harder to get approved for since the lack of collateral means a higher risk for lenders. You might need a slightly higher credit score to qualify for an unsecured loan, and you can expect to pay more interest on it than you would on a secured loan.
Is a credit builder loan right for me?
Your credit score influences almost all of the major financial decisions you’ll make in a lifetime. Maintaining a good credit standing will impact your ability to finance things like a car, a home or a college education. If you have a poor credit history, finding ways to improve your credit score is a responsible and worthwhile goal.
A credit builder loan can be a helpful tool if you need to build your credit from the ground up or improve a poor credit score. Remember that this type of loan won’t give you immediate access to any funds, so keep this in mind when deciding whether or not it’s right for you. But if you have a small sum of money you can afford to part with, putting it toward a credit builder loan is certainly an option to start or improve your credit building journey.
Empowering yourself financially requires discipline and patience, especially if you’re climbing out of a bad credit history. But the possibility of financial freedom exists for anyone willing to commit to the process, and there are many resources available to help you along the way. The consultants at Lexington Law can provide you with tools to help you secure a better financial future and guide you through your credit building journey.
Source: lexingtonlaw.com