- These loans help improve credit scores for individuals with limited credit history, secured by a savings account or CD.
- Consistent on-time payments on credit builder loans positively affect credit scores, aiding in credit building or repair.
- Unlike traditional loans, credit builder loans provide a savings opportunity and structured repayment plan without initial funds.
- Completion of a credit builder loan demonstrates responsible credit behavior, positively influencing future lending decisions.
If you’ve made money mistakes in the past and become frustrated when you check your credit score and report, there may be something that can help redeem you — credit builder loans.
Designed specifically for those in need of something to help improve their credit because of no credit or poor credit, these loans offer a structured approach to paying on a loan. By making regular payments on a credit builder loan, borrowers can establish a positive credit history and improve their credit scores. In this blog, we will explore what credit builder loans are, how they work, their benefits and potential pitfalls, as well as strategies for successfully managing them.
What Are Credit Builder Loans?
Credit builder loans are meant to do exactly what’s in their name – build up your credit. Created for people who have no credit or poor credit, they usually range from a few hundred dollars to a few thousand dollars. They are a tool meant to help people establish or increase their credit.
However, they differ from traditional loans in a few ways. Credit builder loans are securely held in a savings account or certificate of deposit (CD). You pay on them every month like traditional loans, and those on-time payments are reported to the credit bureaus.
You also don’t get immediate access to the borrowed funds of a credit builder loan. Rather, the amount of the loan serves as collateral until the loan terms are completed. This set-up keeps the lender safe, and encourages the borrower to make payments on time and in full.
At the end of the loan’s term, the savings account or CD is unlocked, granting the borrower access to the funds. At this point, the borrower's credit score also improves.
A Breakdown of How Credit Builder Loans Work
At its core, a credit builder loan is a financial tool that lets people borrow a small amount of money to show they can repay it on time in the hopes of building up their credit. The lender reports those payments to credit bureaus, and if they’re on-time each month, their credit score will improve. It’s a tool made especially for those with no or poor credit. Here’s a breakdown of the mechanics of a credit builder loan:
First, borrowers must apply for the loan and provide necessary documentation, such as proof of income and their ID. Once approved, the lender holds the loan amount in a separate savings or CD account. You’ll hear the account referred to as “locked” or “secured,” as it’s not a regular savings or CD.
Borrowers then make fixed monthly payments that are deposited into the locked account. These payments (on time, missed, and late) are reported by the lender to credit bureaus, contributing to the borrower's credit history.
Once the loan term is complete, the borrower receives the funds from the locked account, minus any interest or fees charged by the lender, along with their improved credit score, if they made payments on time and in full.
Those with no credit and poor credit may not qualify for regular loans or credit cards. Credit builder loans offer a structured way for borrowers to build up their credit, and because the money is held in a locked account, the risk is less for the lender.
How Credit Builder Loans Can Improve Credit Scores
Yes, if a borrower makes their payments on time and in full on their credit builder loan, their credit score will go up and their credit history will improve. However, how much it goes up, how often it will increase, and other affecting factors come into play.
The average credit score improvement with a credit builder loan can vary depending on individual circumstances, but with consistent payment history and responsible credit management, borrowers can typically expect to see their credit scores increase within a few months. How much your score goes up depends on your starting credit score and the overall credit profile of the borrower.
To get a sense of what the loan may look like for you, WalletHub reports that, “Most credit builder loans run from $300 to $1,000, offer loan terms of 6 to 24 months and have an APR (interest) range of about 6% to 16%.”
Also, if you’ve never opened a credit builder loan before and have a few other types of credit, your score may go up more than the average, as the credit builder loan is diversifying your credit portfolio. Diversity in your credit portfolio helps to raise your score. As the loan progresses, successful repayment builds trust with lenders, potentially leading to more favorable credit terms and access to additional credit options in the future.
Credit Builder Loans Compared To Other Credit-Building Techniques
Although all types of credit, if payments are made on time, help to improve your credit score, credit builder loans are unique in their own right. As mentioned above, they aren’t right or ideal for everyone, mostly meant for those with no established credit or poor credit history.
Also, instead of receiving the loan amount upfront like traditional loans, the borrower agrees to make regular payments over a fixed period of time. These payments are typically held in a separate account, and once the loan is fully repaid, the borrower receives the funds. This may seem counterintuitive – to pay on something without getting something right away – but the point of this type of loan is not so much to get the money, but to prove that you are trustworthy enough to make payments on time and a chance to improve your credit without much risk to the lender.
Compared to other credit-building methods, such as secured credit cards or becoming an authorized user, credit builder loans offer certain advantages. They provide a structured repayment plan, ensuring consistent payments. They also don’t require a security deposit or a co-signer, making them accessible to individuals without many financial resources or a trusted person to co-sign.
Credit builder loans also offer an opportunity to save money while building credit. The funds paid toward the loan are held in a separate account and are usually returned to the borrower after the loan is completed.
A Guide To Getting A Credit Builder Loan
- Understand your credit situation: Before applying for a credit builder loan, it's you should first look at credit to see where you currently stand. Obtain a copy of your credit report from one of the three main credit bureaus and review it for any errors or discrepancies and to get an idea if you’ll qualify or not.
- Research lenders: Look for reputable financial institutions or credit unions that offer credit builder loans. Compare interest rates, terms, and requirements to find the best fit for your needs.
- Gather required documents: Gather the required documents for the loan application. This typically includes your ID, proof of income (pay stub or tax return), and sometimes proof of address (electric bill, etc.). Hint: Have these ready to go while you are applying to make things go faster.
- Determine if loan amount and terms are right for you: Decide on the loan amount you wish to borrow and the repayment term that suits your budget. Note: Credit builder loans are smaller in their amounts, and have shorter payment periods.
- Submit the application: Complete the lender's application form accurately and provide the necessary information and documents.
- Await approval: This may be the most difficult step. After submitting your application, the lender will review it and assess your eligibility. If approved, the funds will typically be held in a separate account (savings or CD, as mentioned above) rather than being disbursed directly to you.
- Make regular payments: Once the loan is approved, make timely payments as agreed upon. We don’t need to tell you again, but it’s extra important: making regular payments on your credit builder loan is the best thing you can do to successfully complete the loan AND boost your credit.
Potential Pitfalls of Credit Builder Loans
Every type of credit you sign on to comes with a certain level of risk. We’re going to focus on the potential risks that come with credit builder loans:
One of the main pitfalls of credit builder loans is the cost. These loans often come with high interest rates and fees. Borrowers may end up paying more in interest than the actual loan amount. This is why it’s important to carefully review the terms and conditions before committing to a credit builder loan to ensure you understand the total cost you are paying.
Another potential pitfall is the risk of default. Credit builder loans typically require collateral or a deposit as security. If you fail to make your payments, you may lose the collateral or forfeit the deposit.
Credit builder loans may also not have a significant impact on your credit score if you already have established credit. (Hence why they are built for those with no credit or poor credit.) If you have a good credit history, these loans may not provide much benefit.
The last risk we want to mention is that this is still a loan. It’s a chance (even a second chance to some) to prove you can make payments on time and in full. If you still feel your money habits are not very healthy, it may not be the right time for a credit builder loan. They require discipline and commitment. You must make regular payments on time to see improvements in your credit score. If you miss payments or default on the loan, it can further damage your credit. Make sure you are 100% ready and able to make the payments before signing off on the loan.
How to Best Handle A Credit Builder Loan
There’s a few best practices when it comes to handling a credit builder loan successfully that we already mentioned up above, like making payments on time (even late payments are reported to credit bureaus), researching lenders, and choosing terms and conditions that best fit your needs. Other important tactics are:
- Budget effectively: Plan your finances to ensure you have sufficient funds available to meet your loan payments. Create a realistic budget that accounts for your monthly expenses, including the loan payment.
- Avoid borrowing more than you can afford: Borrow an amount that aligns with what you can reasonably pay. Taking on excessive debt can strain your budget and hinder your progress in building up your credit.
- Monitor your credit: Regularly review your credit reports to track your progress and identify any errors or discrepancies. Seeing your credit go up can also help you to stay on track with regular payments.
- Resist new debt: While repaying your credit builder loan, avoid accumulating extra debt. Focus on improving your credit with just the credit accounts you currently have. This whole process is about creating healthy credit habits, too.
- Patience and perseverance: Building credit takes time. Be patient and stay committed to the process, knowing that consistent efforts will yield positive results.
How Lenders View Credit Builder Loans
Let’s the flip the script quick, and examine how lenders view credit builder loans, in particular when you apply for future credit opportunities after completing a credit builder loan.
Lenders generally view credit builder loans positively when assessing future credit opportunities for borrowers who have completed them. From a lender's perspective, a completed credit builder loan demonstrates a borrower's commitment and ability to manage credit responsibly. Lenders value this level of discipline and responsibility, as it reduces the perceived risk associated with giving credit to the borrower.
However, it's important to note that while a credit builder loan can improve your creditworthiness, it doesn't guarantee automatic approval for future credit applications. Lenders consider multiple factors when assessing credit applications, including income, employment history, and debt-to-income ratio.
The Future of Credit Builder Loans
One prominent trend in credit builder loans is the integration of technology. Financial institutions are leveraging advanced algorithms and artificial intelligence to streamline the loan application and approval processes.
Credit builder loans are also becoming more flexible and accessible. Traditional lending institutions are now being joined by fintech startups and online lenders, offering a wider range of credit options to borrowers, including credit builder loans.
Another emerging trend is the integration of financial education and resources into credit builder loan programs. Lenders are recognizing the importance of empowering borrowers with knowledge and tools to make better financial decisions. They usually provide educational materials, budgeting assistance, and credit counseling services.
Some credit builder loan lenders are using other data sources besides credit scores to determine if they will lend to you or not. They are considering factors like utility payments, rental history, and employment records to evaluate borrowers' creditworthiness.
The bottom line is credit builder loans are valuable tools for individuals with no credit or poor credit who are seeking to establish or improve their credit scores. These loans work by holding the borrowed amount in a separate account while the borrower makes regular monthly payments. The lender reports these payments to credit bureaus, helping to build a positive credit history. While credit builder loans may have high interest rates and fees, they offer structured repayment plans and do not require a security deposit or a co-signer.
It's essential to budget effectively, avoid excessive borrowing, and monitor credit progress while handling a credit builder loan. Lenders generally view credit builder loans positively, and advancements in technology are making these loans more accessible and flexible, often accompanied by financial education resources.
We hope that after learning everything you could ever want to know about credit builder loans, you are educated and empowered enough to explore applying for your own! You can start your journey to better credit here.
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