When it comes to establishing credit history from scratch, or rebuilding credit, the top two “starter” products are generally a credit builder loan and a secured credit card.
Why? Because these products tend to have fewer barriers to access than some other credit products, since they were designed to help people with bad credit or no credit get started building it.
But what exactly are these two credit-building tools and what should you watch out for when trying to use them to improve your credit? Which should you get first, how do they work and how do they work together to help you build even more credit?
Here’s the breakdown to help you out.
But first, a small disclaimer.
First, notice I use the word “tools” to describe these products. That’s because, like any tool, how you use them is what really matters. If used responsibly, these tools can help you build or rebuild your credit. But if used irresponsibly these tools could hurt, rather than help, your credit.
Responsible use, in a nutshell, means paying on time, in full, every time, and carefully monitoring your credit utilization, since these factors have a major impact on your credit score.
A secured credit card (also sometimes called a credit builder card) works just like a regular credit card, with one major difference – a secured card requires a security deposit as collateral in case you don’t pay what you owe.
The security deposit usually starts at about $200 and sets your credit limit, which is the max you can spend before paying down your balance on the card.
As long as you pay off any remaining balance or fees, this deposit is fully refundable if you ever decide to close the account. These cards are generally considered starter cards since the credit limits are usually lower than unsecured credit cards and because they’re secured by your deposit, they’re lower risk for the credit card issuer.
Each month as you make purchases and pay the balance, you build credit because the lender reports your credit history to the credit reporting bureaus. Whenever possible, try to pay off the entire balance to avoid interest charges.
Also important to note: A secured card works differently than a debit card. For secured cards, the security deposit only covers your balance if you fail to pay the lender, whereas a debit card pulls directly from the money already in your bank account.
Remember, a credit card isn’t extra income. So while it can be helpful to have in case of an emergency, relying on it too much could mean racking up credit card debt that can be tough to pay off.
A credit builder loan works differently than a traditional personal loan. Unlike a traditional loan, where you get money right away then pay it back, a credit builder loan is purely to build your credit. Some people also view it as a savings tool, since you pay money into a type of savings account and get the money back (minus interest and fees) at the end.
Here’s how it works:
Some credit builder loans, like the ones at Self, do not require a hard credit check, good credit, or even any credit at all to get started. These loans could be good for someone who is brand new to credit, has been denied a credit card, or is not able to afford the deposit for a secured credit card.
Together, a credit builder loan and a secured credit card can be a powerful starter kit for establishing or rebuilding your credit.
The key lies in the idea of “credit mix”. Your credit mix, or types of credit, counts for 10% of your FICO credit score, and is one of the 5 major factors that impacts your score.
There are two types of credit:
Installment credit includes loans you pay in regular “installments” or chunks. While these installments are usually paid monthly, sometimes you’ll find quarterly or even annual installments instead. These types of credit have a specific start and end date.
Examples of installment loans include:
Revolving credit is a credit line that has no set end date, but keeps rolling over as you keep paying down the balance. Revolving credit includes things like credit cards, secured credit cards, or Home Equity Lines of Credit (HELOC).
Having a mix of credit types plays a role in your credit score and on your credit report because each type comes with a different set of risks and responsibilities. (Learn how to read your credit report Lenders want to see that you can manage each type of credit well, and ultimately, pay back what they lend you.
Since a credit builder loan counts as an installment loan, and a secured credit card counts as a revolving line of credit, if you use them both well together, you could be on the path to building better credit, whatever your goals for the future might be.
Is one credit type better than the other? Is there one you absolutely have to start with? The quick answer is no. The longer answer is that it depends on your needs and current credit situation.
If you have poor or no credit, you might just start with whatever credit product you can get first so you can build credit and unlock access to other credit products later. Ultimately, you have to start building credit somewhere.
To help you decide where to start, here are two different paths you could take to jump-start your credit-building.
Generally speaking, a credit builder loan has a lower barrier of entry than a secured credit card. This is because credit builder loans, especially the ones offered by Self, don’t do a hard credit check and don’t require a large, upfront deposit.
Depending on your goals and situation, a credit builder loan could be the perfect place to start building your credit.
There’s now even an option that will let you start with a credit builder loan to build credit and save money towards a security deposit, then unlock access to a secured credit card once you reach a certain threshold for your deposit.
As of the date this article was posted, the only company that currently lets you do this is Self, with the launch of the Self Visa® Credit Card.
The cool thing about this option is, if you follow the steps of the Self process, you can get two credit products, of two different credit types with no hard inquiry and no extra security deposit needed.
If you already have some credit and can afford an upfront security deposit of a couple hundred dollars, you could also consider skipping the credit builder loan and starting with a secured credit card.
You’ll have the best chance of being able to skip that first step of a credit builder loan if your credit score is already at least in the fair range (meaning between 580-669, according to Experian).
After several months of proving positive payment behaviors and responsible card usage, some credit card issuers will let you move on to a partially secured card or an unsecured credit card with a higher credit limit. They will then refund your security deposit.
So if your credit is fair and your primary goal is to get an unsecured credit card, this might be your best option for now.
Since your payment history is the #1 factor that impacts your credit score, the right type of credit to start with is the one you can use responsibly and pay on time every time. Otherwise you could hurt your credit, rather than help it.
Here are a few things to watch out for so you can maximize the credit-building power of these two products and avoid some of the pitfalls.
Making payments on time is the biggest way to either improve or maintain your credit score, since credit bureaus care about on-time payments the most. Set up autopay on your credit accounts to avoid missed or late payments.
Paying on time works for both a credit builder account and a secured credit card. Remember that your secured card payments could vary month by month, so make sure you have enough in your account to cover automatic payments. That way you don’t get charged any returned or failed payment fees.
No matter what else you do, never miss a payment or pay late! If you accidentally pay late, make a payment as soon as possible. Many credit card companies won’t report it late to the credit bureau unless it’s 30 days late or more.
Many credit card companies charge a late fee that kicks in sooner than the 30-day credit-reporting grace period. So paying on time not only helps you build your credit, it also helps you avoid other unwanted fees.
Interest rates work differently for installment loans and revolving credit. Understanding that difference, and how it could impact you, is important.
Installment loans, like credit builder loans, charge interest as part of your monthly payment on the loan. Meaning each time you make a payment, you have to pay a portion of the interest too. Depending on your loan terms, this interest is either a fixed rate or it’s variable.
With the Self Credit Builder Account the interest rate is fixed, meaning it doesn’t change from month to month.
The interest rates on revolving credit, like a secured credit card, work differently. While many people shop for a credit card based solely on the interest rate, you can avoid paying interest completely.
If you pay off your balance in full, either on or before the due date each month,you will never have to worry about the interest rate on your credit card. That’s because the only time you’ll pay interest on a card is if you carry a balance from month to month, or only pay the minimum amount due.
When you have a fixed interest rate on an installment loan, you pay the same amount on a regular basis, usually monthly, and the amount you owe includes a combo of principal and interest.
There’s no minimum payment because you must pay the full amount owed each month to comply with the loan terms. If you only pay a portion, the lender likely will not count the payment as an on-time payment, and it could negatively affect your credit report.
With revolving credit, the amount you owe each month can vary up to a maximum credit limit, since it’s based on your spending habits. But there is a minimum amount you must pay, which is usually about $25 or a small percentage of your current outstanding balance.
Unlike installment credit, with credit cards you don’t have to pay the full balance each month. Paying just the minimum amount due each month is enough to show on-time payment history on your credit report and build credit.
If you don’t pay the full balance on your credit card, though, you’ll start to get charged interest!
The amounts you owe, also known as your credit utilization ratio, counts for 30% of your FICO credit score, which is the second biggest factor after your payment history. The amounts you owe works slightly differently across both types of credit, according to credit expert Barry Paperno.
Your credit utilization is an important factor in your credit score because it shows how you manage your debt on a regular basis.
Your credit utilization ratio is calculated by dividing how much you owe by the maximum amount you can borrow.
While installment loans add the final loan amount as part of what you owe on your credit report, installment utilization makes up much less of your credit score than revolving credit utilization, according to Paperno.
Installment utilization looks at your current balance on the loan versus the original loan balance. At the beginning of the loan, for example, your installment utilization will be high (close to 100% after your first payment) and low as you approach the end of the loan.
With revolving credit, like a secured credit card, utilization is calculated by dividing your credit limit by your current balance. It’s determined for each credit card individually, as well as across all of your cards.
For example, if you have a credit limit of $1,000, and you use $300, you have a 30% credit utilization ratio.
Due to paying down or paying off your balance each month on a credit card, this number can change more frequently than the amounts you owe on any loan. This utilization is reported to the credit bureaus each month, and could impact your credit score on a month-to-month basis.
Generally speaking, especially when it comes to credit cards, the lower you keep your utilization (meaning the closer you can keep your end-of-the-month balance to zero) the better your credit score could be.
While individually either a credit builder loan or a secured credit card can be a great tool for building credit, having a mix of both types of accounts on your credit report could be the power punch you need to start building a healthy credit profile.
And the healthier your credit score, the more likely you are to get access to whatever credit products you want (and at more competitive interest rates) down the line.
Lauren Bringle is an Accredited Financial Counselor® and Content Marketing Manager with Self Financial – a financial technology company with a mission to help people build credit and savings.