Credit Builder Loan 101: How it Works, Types, Benefits and Alternatives

Last Updated: June 4, 2019
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A credit builder loan helps individuals build their credit by providing them with an opportunity to show their creditworthiness through small monthly payments. How does it works, what are the different types of such loans, their benefits and also - the alternatives.

You could say that a credit-builder loan is like manna from heaven for people who have poor credit or who have little or no credit history.  Why?

It’s because this loan will help them build credit.  Then, if they are able to 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.

What makes credit-builder loans unique is that they do not require good credit for approval, unlike credit cards or personal loans.

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.  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 that come from your credit reports, making on-time payments will have a big positive impact on your score.

What is a Credit Builder Loan?

Perhaps, to many borrowers, the hardest element to build good credit, whether from the ground up or repairing a bad credit history, is patience.  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 normally issues credit builder loans, will first deposit a small amount of money into secured 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 time.  Of course, the monthly payment will have an interest component.

At the end of the loan’s term, which normally ranges from six months to two years, provided the borrower has paid off the loan, the bank releases the money to the borrower.  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 will be able to 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 Credit Builder Loan Works

How a Credit Builder Loan Boosts Your Credit

A credit builder loan helps individuals build their credit by providing them with an opportunity 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 payment until they’ve fully paid off the loan according to its terms.

Next, let’s see what it does to the credit scores.  After a borrower has started building a credit history and established trade lines in use, he begins to develop his credit scoreFICO and VantageScore are the two most popular measures and both range 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.

Naturally, when building your credit score, you will have to 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.  In terms of scoring, the two most critical scoring factors are your payment history and your debt utilization ratio (amount of actual debt over the amount of credit that you have).

Apply Only For Credit You Can Get

However, the length of credit, types of credit in use and pursuit of credit are also important factors that go into your score. There is no shortcut because you can’t speed up the terms of the loan but you could get several loans simultaneously to show that you can well manage multiple accounts. A word of caution:  apply only for credit that you’re somehow sure you can get because hard inquiries that will result 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.

How a Credit Builder Loan Boosts Your Credit

Types of Credit Builder Loans

Basically, credit builder loans fall under two types: pure credit builder loans and share secured loans.

1. Pure Credit Builder Loans

Pure credit builder loans achieve two important objectives for the borrower.  It helps a borrower put up a savings account while building up credit at the same time.  The lender puts the entire loan proceeds in a savings account under the borrower’s name where it stays frozen until the borrower pays off the whole 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 and he can use it as the deposit on a secured credit card.  More importantly, the loan history goes into his credit report and becomes a good entry to help improve his credit score.

This strategy has many other uses such as building savings for a down payment for a car.  Adding good entries into your credit history will improve your credit score over time and once you have a more ideal score, you could haggle for a lower interest rate on an auto loan.

2. 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.  The bank will freeze the funds in the account and unfreezes them commensurately to the loan payments that the borrower makes.

Why would someone go through all this trouble?  Basically, this scheme is very good if a person wants to improve 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 a “fair” to “good”.  For them, the slight difference between the interest on the deposit and interest on the loan is worth going through the process.

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 small uptick because share secured loans are normally small short-term loans.

Creditors will now be more open to lending you money because you have shown that you can handle month-to-month payments.  They are ideal for consumers who want to start a credit history or someone who wants to repair damaged credit.

How Can You Get a Loan to Build Credit

Credit-builder loans could be an easy way to build or rebuild credit but they are not the most common.  It would take some effort on the borrower to find a lender that offers one.  But since they are a secure, safe means of improving a credit score, they’re worth going to great lengths to find one.

You may look for a credit-builder loan at the following:

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.

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 that can offer 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.

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:

Apply For a Secured Credit Card

A secured credit card works the same way as a credit-builder loan in terms of trying to build or rebuild credit history.  The application process is practically the same except that issuers of a secured credit card will require a deposit of around $50 to $300 into a separate account.  The bank will issue the borrower a line of credit that’s usually equal to the amount in a deposit.  This way, the borrower can build a credit history without exposing the lender at risk.

Some credit card companies will allow their borrowers to “graduate” and level up to a traditional credit card after they’ve proven that 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.

vThese types of card 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%.

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 and 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.  Looking at it from that point of view, it’s an expensive way for an individual to build credit.

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.

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