What is a Credit Builder Loan?

what's a credit builder loan?

By Zina Kumok

Building credit from scratch is kind of like applying for entry-level job positions. Those job listings almost always require several years of relevant experience, but how do you get experience without working an entry-level job?

Likewise, building credit can be difficult when most loans and credit cards require an existing credit score. You may be able to find a traditional debt product aimed at consumers with poor or no credit, but they’re likely to come with exorbitant fees and sky-high interest rates.

It’s the Catch-22 of credit – you have to have it to get it, but you can’t get it unless you have it.

That’s where credit builder loans come in. They allow people to borrow with minimal risk for the lender, so consumers have the opportunity to build or rebuild their credit. Read ahead for everything you need to know.

What is a credit builder loan?

A credit builder loan is exactly what it sounds like - a loan that helps borrowers build credit. It’s a type of installment loan typically targeted at people who are completely new to credit and want to build credit history responsibly. They can also work well for anyone with bad credit or poor credit.

Here’s how it works:

  1. You apply for and open a credit builder account at a bank, credit union or through Self.
  2. When your application is granted, the financial institution moves the loan proceeds you were approved for into a separate account, usually a savings account or certificate of deposit (CD). The funds are usually small, between $300 and $1,000, though some banks offer credit builder loans as high as $2,500.
  3. The borrower then begins making small monthly payments for a predetermined amount of time. Loan terms can be as short as six months or as long as six years. Once the loan balance reaches zero, the service provider unlocks the CD and returns the total money the borrower paid, minus any interest and administrative fees.

The main difference between a credit builder loan and a traditional loan is that you don’t receive a lump sum at the beginning, but rather at the end. By holding onto the loan funds as you make payments, the lender is able to avoid any risk while you prove yourself as a reliable borrower.

How credit builder loans add positive credit history

While you’re making loan payments, the lender should report your payment activity to all three credit bureaus: Experian, Equifax and TransUnion.

Remember, your payment history counts for 35% of your FICO credit score. If you make your payments on time and in full each month, this should help build positive payment history with the major credit bureaus, and could improve your credit score.

There are several factors that influence credit scores, but the most important is whether or not you make payments on time.

Opening a credit builder loan can help you build this payment history, since part of the process involves making monthly payments. Remember that this type of loan, like any financial product, is really just a tool, so how you use it matters. If you make payments on time, the lender will report positive payment history to the credit bureaus, which could lead to good credit.

If, on the other hand, your payments are late or not for the full amount, your lender reports that to the credit bureaus too, which could lower your credit score.

Because most credit builder loans have a term of 12 months or more, you’ll have a solid history of on-time payments once your credit builder loan is completed. This could not only improve your credit score, it could make you a more attractive candidate for other loans, like a personal loan, mortgage or car loan.

Once you’ve opened a credit builder loan, you can start monitoring your credit progress through sites like Credit Karma. If you open a credit builder loan through Self, you’ll get access to your credit score. Try to check it once a month to make sure your score is improving. Checking your credit score regularly will also alert you if anyone steals your identity or opens a new loan in your name.

There’s one more benefit to choosing a credit builder loan - they tend to be more affordable than some other options. Self loans, for example, have monthly payments starting as low as $25 a month.

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How to qualify for a credit builder loan

Because a credit builder loan is designed for those with no credit, you don’t need a good score to be eligible. You can even apply if you don’t have any credit history at all.

You just have to be at least 18 years old and a US citizen or permanent resident, have a Social Security number and have a bank account, debit card or prepaid card. If you’re reading this article, chances are you would have no problem qualifying for a credit builder loan.

You can find a credit builder loan through certain community banks, local credit unions or at Self, which is available online or via a mobile app in all 50 states. Just remember to compare terms and shop around when looking for a loan.

Other ways to build your credit

Credit builder loans aren’t the only way you can improve your credit responsibly. A secured credit card is another popular way to build credit. Unlike a unsecured credit cards, a secured card requires a deposit to act as collateral. Usually the deposit is small, between $200 and $2,000. The deposit will equal the card’s credit limit, and you have to submit the deposit before you receive the card.

You can use the secured card at retailers just like any other credit card. Just make sure the provider reports to all three credit bureaus. After a few months of using the card responsibly, the provider may upgrade you to a traditional credit card.

If you’re going to use a secured credit card, just remember to use your credit wisely. A secured card has a low credit limit, so it’s easy to use more than 30% of the available credit line. Your credit utilization percentage makes up 30% of your total credit score, making it the second highest factor in determining your score.

If you have a secured card with a $200 credit limit, you could notice a negative impact on your credit report if you have a balance of more than $60. You can rack up that amount easily just with one trip to the grocery store. Be sure to monitor your usage carefully to ensure you don’t go over the 30% ratio.

Don’t forget about the interest either. If you don’t pay your balance in full by the due date, you’ll be charged interest. Secured cards typically have higher interest rates than traditional credit cards, so this mistake can be costly.

Why pick a credit builder loan?

By typically having a low annual percentage rate, relatively small loan amounts and relatively brief loan terms, credit builder loans are designed to increase the likelihood that you can repay the loan and build positive credit. The nice thing is unlike with a credit card, you can’t rack up a huge amount of card charges.

You still have to be responsible when using a credit builder loan. If you miss a payment, the lender will have to report that to the credit bureaus. This can be extremely damaging if you don’t have a long credit history to fall back on, which is true for many people who take out a credit builder loan to establish credit. One late payment can make a huge impact.

To avoid this, set up automatic payments from your bank account to your credit builder loan. Double check to make sure the monthly payment went through, and don’t be afraid to use calendar reminders as an extra precaution. This can help get you on the right track towards being a responsible borrower and help establish good habits to use for your next secured loan.

About the author

Zina Kumok writes extensively about personal finance with a focus on budgeting and debt elimination. Her work has appeared in publications as diverse as Forbes, Mint and LendingTree.

Written on April 3, 2019

Self is a venture-backed startup that helps people build credit and savings. Comments? Questions? Send us a note at hello@self.inc.

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