What Is A Credit-Builder Loan And How Does It Work?

Table of Contents What is a credit-builder loan?How does a credit-builder loan work?How to use…

If you want to build credit but your score isn’t strong enough to get approved for a traditional credit card or loan, you may wonder what your options are. A credit-builder loan could be useful in this situation.

These loan products cater to credit newbies or credit-challenged consumers and offer the best of both worlds — the ability to potentially build credit while saving money.

What is a credit-builder loan?

A credit-builder loan is a financial product with competitive terms that helps you build credit while saving money. It’s ideal for individuals who have bad credit or no credit at all and have trouble getting approved for credit cards or traditional loan products.

Loans are generally available in hundred dollar increments, from $200 to $2,000, with repayment periods from six to 24 months.

How does a credit-builder loan work?

If you’re approved for a credit-builder loan, the bank will deposit the entire loan amount into an interest-earning savings account. You’ll make a fixed monthly payment for a set period and receive the loan proceeds (minus applicable fees) at the end of the loan term.

Most lenders charge an administrative fee to open an account. Monthly payments are usually automatically deducted from your bank account to streamline the repayment process and prevent you from missing payments.

The impact on your credit score generally depends on your credit history. A recent study from the Consumer Financial Protection Bureau (CFPB) which consisted of roughly 1,500 consumers revealed that participants without debt who opened credit builder loans saw an increase of 60 points more in their credit scores than those with existing debt. Consumers who had existing debts experienced a decrease in their credit scores.

How to use a credit-builder loan to your advantage

Credit builder loans help you build credit by reporting monthly payments to the three credit bureaus — Experian, TransUnion and Equifax. Payment history accounts for 35 percent of your FICO score, so timely payments boost the amount of positive activity reported in your credit profile. In turn, your credit score could improve over time.

Plus, you’ll build up savings while making payments towards your credit-builder loan balance. Once the funds are released, you can stow them away in a savings account, make a big-ticket purchase or use them however you see fit.

Where to get a credit-builder loan

Credit-builder loans are available through an assortment of lenders, including:

  • Credit unions: If you aren’t yet a member of a credit union, you’ll typically need to apply for membership before you can apply for a credit-builder loan.
  • Community banks: You likely won’t find these loan products through large brick-and-mortar banks, but many local, regional and community banks offer credit-builder loans.
  • Lending circles: They offer credit-building plans, which entail interest-free loans that report to the credit bureaus, for use by groups of relatives or friends. Each member deposits the agreed-upon amount into a central fund each month. Every month, a member of the fund receives cash, and everyone continues to pay in until all the members have received money from the central fund. Refer to the database on nonprofit Mission Asset Fund’s website to find lending circles in your community.
  • Online lenders: Several online lenders, like Self, feature low-cost credit-builder loans that you can apply for and receive a decision in minutes. If you’re leaning towards a credit-builder loan, confirm the lender is licensed to do business in your state before applying.

Most lenders don’t require a credit check to qualify for a credit-builder loan. However, they may review your banking history through ChexSystems, Early Warning Systems or another consumer reporting agency to determine your eligibility for a loan – adverse entries, like bounced checks and excessive overdraft fees, could hurt your chances of getting approved.

When you’re ready to apply, you’ll usually be asked to provide the following information and documentation:

  • Your name, date of birth and Social Security number
  • Your current address and phone number
  • Your routing and bank account number
  • A copy of your driver’s license, U.S. passport or state-issued photo identification
  • Your monthly mortgage or rental payment

Other ways to build credit

A credit-builder loan is just one way to begin your journey towards better credit. There are other alternatives to consider, including:

  • Secured credit cards: You’ll get access to a credit card with a limit that’s based on the required security deposit you make upfront. A secured credit card can be used like any other credit card, and you’ll need to pay at least the minimum payment each month to keep the account in good standing as payment activity is reported to the credit bureaus each month. Ideally, you want to keep the balance at or below 30 percent of the credit limit to help boost your score.
  • Personal loans: Some lenders offer unsecured personal loans to those with poor or limited credit histories. However, these loans may not be worthwhile as they’ll likely come with a steep interest rate since they pose an elevated risk to the lender. If you can get a secured loan backed by collateral, you could qualify for more favorable terms.
  • Self-reporting: Ask your landlord and service providers to report payment activity to the credit bureaus. They’re not obligated to do so but could grant your request for free or in exchange for a nominal monthly fee.

You can also ask a relative or friend with exceptional credit history to add you to their credit card account as an authorized user. If they agree, you’ll have the authority to make purchases on the account without being on the hook for payments. Even better, you won’t have to undergo a credit check, and all the positive payment history from the account will also reflect on your credit report. You can request to be removed from the account as an authorized user at any time.

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