According to the credit scoring company FICO, the average credit score for consumers in the U.S. is 704.
Given that the scale is 300 to 850, that’s actually not too bad. But if you find yourself on the lower end of the credit spectrum — or among the millions of Americans who are credit invisible — you might think attaining even the average score is out of your reach.
That’s not necessarily the case. With a credit builder loan, you can establish a credit history and potentially improve your score if it’s less than ideal. And the higher you can get your score, the more access you’ll have to better interest rates if you do decide to apply for a personal loan, an auto loan, or even a mortgage. In the long run, those lower interest rates you earn with good credit could potentially save you tens — or even hundreds — of thousands of dollars.
However, if you’re hoping to make a big purchase in the next five years, you’ll need a multi-pronged strategy to achieve your goal. In addition to improving your credit, you’ll need to save some money. After all, you’ll need to have enough for a down payment on that house or car you’re planning on buying.
Luckily, there are a variety of financial tools available to help you maximize your savings, one of which can simultaneously help you make sure you stay up-to-date on your credit builder loan payments. Enter the money market account.
Here, we’ll explain what credit builder loans and money market accounts are, who should use them, and how they can work in tandem to help you achieve your financial goals.
First of all, it’s important to understand why you might want to take out a credit builder loan, and in order to do that you’ll need to know the basics of how building credit works.
Your credit score is essentially a number lenders use to gauge the likelihood that you will pay back the money you borrow on time and in full. That score is derived from a credit report, which provides a detailed report of your credit history. (Learn how to read a credit report.)
There are various factors that go into determining that score: payment history, credit utilization, length of credit history, types of credit, and new credit accounts or new inquiries into your credit history.
While all five factors are important, some have a greater influence on your final credit score. For instance, FICO, one of the two major credit scoring models, weights the five major factors accordingly:
Payment history is the most heavily weighted of the five credit scoring criteria, so one of the most effective ways you can improve your credit score is by ensuring you have a history of on-time, in full payments. That’s where a credit builder loan can come in handy.
A credit builder loan is exactly what it sounds like — a loan that helps borrowers to either establish a credit history or improve an existing credit score. Like most loans, borrowers repay the loan in monthly installments to the issuing bank or credit union, and those repayments are reported to the three major credit bureaus — Equifax, Experian and TransUnion.
However, unlike more traditional loans, you don’t receive a lump sum at the beginning, but rather at the end of the loan term. Because the lender holds the loan funds as you make payments, they are able to avoid risk, while also allowing you to prove that you are a reliable borrower.
In short, it works like this:
While credit builder loans are an excellent financial tool to help you build credit, they’re not for everyone. For example, if you already have a good credit score, you likely won’t need to apply for this type of loan. Additionally, if you already have an unsecured or secured credit card, you can use that card to help build your credit without the need for a credit builder loan.
If you need access to the funds from the loan immediately, this arrangement won’t work for you. Because the bank or lender has the funds for “safekeeping” while your credit history gets built, your steady loan payments build up the balance and you gain access to the loan at the end.
That said, there are numerous situations where a credit builder loan could be greatly beneficial. For instance, you might want to take out this type of loan if:
In this case, an example might help. Let’s look at Sarah’s situation. Sarah falls into the last category — she already has a secured credit card, but has used it irresponsibly in the past. In her early 20s, she spent more than she could afford to repay, and as a result was unable to pay her credit card on time and in full every month by the due date. These late payments caused her credit score to drop drastically to 660.
Sarah is now nearing 30 years old, and knows that she wants to buy a new car in the next two years. However, she also knows that she needs to improve her credit score if she wants to get a lower interest rate on an auto loan. In an effort to improve her score from 660 to above 670 — or what many lenders consider a “good” credit score — she begins religiously making on-time payments on her secured credit card. She also decides to take out a credit builder loan to improve her score even further in the two-year period.
Sarah opens her account today with a $15 account activation fee, then punctually pays the lending financial institution her agreed-upon $25 a month payment for the full 24 months of the loan. The financial institution takes Sarah’s monthly payments and places them in a Certificate of Deposit (CD), where it earns interest. Then, at the end of the 24 months, Sarah withdraws the full amount — $526, what’s left of her $600 in total deposits minus finance charges on her loan — from her account.
In Sarah’s case, the benefits are twofold:
When you have a specific financial goal in mind — in Sarah’s case she knows she wants to buy a car — it’s often a good idea to optimize your savings in addition to ensuring you have the best credit score possible. A money market account is among the best options when it comes to maximizing your savings goals for a relatively short-term purchase (less than five years).
A money market account (MMA) is like a high-yield savings account that you can open with a bank or credit union. However, in contrast to regular savings account rates, MMAs offer higher interest rates. For instance, many of the best money market accounts offer higher rates of interest with an annual percentage yield (APY) of over 2%.
While the high interest rates and low risk of a money market savings account can make it very attractive to those who’d like to save for a short-term goal, it’s always important to consider both the pros and cons of any savings vehicle.
MMAs are an excellent place to keep a large chunk of change in a safe place for a short-term goal since they’re FDIC-insured, offer a relatively high interest rate and have high liquidity. MMAs tend to work well for your emergency fund, buying a home or car, or saving for tax payments.
But as with credit builder loans, there are various criteria you should look at to determine if you’re a good candidate for this type of account:
Again, an example might help. Returning to Sarah’s situation, we know that she wants to buy a car in two years. She knows she will need to improve her credit in order to get the lowest possible interest rate on her future auto loan. She also knows that she’ll need to save enough money for a down payment.
Now, because Sarah is committed to her goals, she started saving last year and already has $2,500 in her bank account. Around the same time she takes out her credit builder loan, she also decides to use that $2,500 as her minimum opening deposit to open a money market account with an APY (“annual percentage yield,” meaning the annualized earnings for this account that considers any effects of compound interest) of 2.50%. Over the course of two years, even if she adds nothing else to her MMA, she will still make approximately $100 in interest without lifting a finger.
While a credit building loan can help borrowers either establish a credit history or build credit, it can only do so if you pay back the loan on time. This is where a high-yield money market account might be helpful, as you could potentially use the interest generated by your MMA to help make payments on your credit builder loan if money in other accounts gets tight.
Because monthly payments on credit builder loans usually range between $25 and $150 each month, you might actually be able to leverage the interest you earn in your MMA to pay off your credit builder loan if need be.
Let’s revisit Sarah’s circumstances. At 12 months into the repayment of her credit builder loan, she runs into some unexpected expenses that disrupt her monthly cash flow. As a result, she finds that her checking account balance will be a bit short when it comes time to repay her credit builder loan.
Luckily, she started her MMA account around the same time she took out the loan. Sarah hasn’t withdrawn any of her initial funds and she’s paid no fees, so she’s earned about $60 in interest. As her money market account is highly liquid, she can easily withdraw some of the interest she’s earned from that account to pay the required loan payment without reducing her initial MMA balance.
If you have financial goals like Sarah, there are multiple financial tools available to strengthen your credit score and eventually help you achieve those goals. By using certain accounts optimally, like the credit builder loan and the money market account, you can often reach your goals more quickly than you ever thought possible and create a better financial future.
Karen Fukumura is Co-Founder and Chief Banking Officer at Novi Money. She formerly led Retail Banking and Operations at East West Bank, helping to grow its assets from $9bn to $33bn. She received her MBA from The Wharton School and is passionate about personal finance and helping others reach financial freedom.