If you currently have a poor credit score and you’re looking to improve it without borrowing large sums, a credit builder loan may be the solution for you.
Consumers use a credit-builder loan with the sole purpose of improving their credit scores. This is because credit builder loans function the opposite of a common loan. You don’t need a high credit score or other requirements to qualify for a credit builder loan, so it’s a good way of improving your credit score even if you have a poor credit score on your credit report.
In other words, you agree to pay money to the lender in installments, and this amount goes to a saving account. When you pay all the installments, you’ll receive the money. In exchange, the lenders will report your loan payments to the credit reporting bureaus. It will be more important than ever not to make any late payments.
However, you might still need to pay interest rates or fees, but in some cases, you may receive back a large percentage of saving from future interest rates in the end.
If this is the first time you hear about credit-builder or secured installment loans, it may sound strange. Remember, their only purpose is to improve your low credit score by reporting accurate monthly payments to the three major credit reporting bureaus.
How can a credit builder loan vs. a traditional loan improve your credit score?
Most financial products require a good or excellent credit score. By using a credit builder loan, you take advantage of building a good payment history. This type of loan usually requires small payments so that you can handle them easily.
Payment history and timely payments are the most important ranking factor on both the FICO score (35-40%) and VantageScore (40%). Thus, you can affect the most important credit scoring factor by making small on-time payments. Lenders will probably report these payments on the credit reporting bureaus, and your credit score will eventually improve.
Also, the credit builder loans let you build a good payment history without applying for a regular loan that you may not need or cannot afford. Credit builder loans involve no risk for the lenders, so you can be approved for one even if you have a poor credit score.
Of course, you have to make full on-time payments for this method to work. Otherwise, there’s no point in applying for a credit builder loan.
How do credit builder loans work?
They work the complete opposite of a normal loan:
- Creditors open a savings account: They add the agreed amount to this bank account. You don’t have access to it until you fully pay the loan, including the interest rates.
- You make monthly installment payments: Most credit builder loans run between $300-$3,000, and the loan term will be between 6-24 months using monthly installment payments. The point is to report accurate payments monthly, so there’s no need to try to pay it off sooner.
- Creditors report your activity to the three major credit bureaus: No matter if your payments are full, on-time, or late, the creditors will be reporting them. Thus, if you fail to make accurate monthly payments, your credit score will decrease and vice versa.
- Creditors also charge interest rates: The annual percentage rate for credit builder loans usually varies from 6%-16%. However, you earn some money by interest if your creditor has opened an interest-bearing account. Further, some lenders will return a portion of the interest when you have fully paid the amount.
- You receive the amount: After you’ve made all the necessary payments, creditors will grant you access to the savings account or transfer the funds to an account of your choice. You can use these funds as you wish.
Although the credit builder loans work the complete opposite of the common loans, the initial approval phase is similar. The exception is that they’re not high requirements to get approved for this kind of loan.
Do your due diligence
First of all, you’ll need to research the market and compare and look at more than one financial institution:
- Amount of loan
- Annual Percentage Rate or APR
- If the account is interest-bearing
Once you find the most suitable credit builder loan for you, you’ll follow an application process similar to getting a regular loan. You’ll need to provide your personal details and probably proof of income, employment, housing status, or existing bank accounts.
The best way to pay it back is to put the loan proceeds into the account and have the payments automatically taken out. I would also add the amount of interest and finance charge to the account as soon as possible to not have to worry about missing a payment as you approach the end of the loan.
Where can you get a credit builder loan?
If you’re willing to apply for a credit builder loan, you can look at:
- Banks: Local community banks are the most common places to apply for a credit builder loan
- Credit Unions: These are financial institutions, and you need to become a member first to apply for a credit builder loan. It’s usually easy and free to join them. However, you might need to meet some criteria, such as living or working at a certain place.
- Online lenders: Some online lenders offer this kind of loan as well. Of course, you have to make sure they can be trusted. You can achieve that by researching reviews online.
Make sure you compare the above-mentioned criteria to choose the best options for you.
Are there any good credit builder loan alternatives?
A credit builder loan is a good option for consumers with poor or no credit to build their credit scores. However, there are some other alternatives to achieve this purpose, such as:
- Credit Cards: If you’re not in good standing or don’t have a credit score yet, you can probably qualify for a secured credit card. Of course, you’ll have to make the minimum security deposit which usually starts from $200-$300. There are also some unsecured credit cards that don’t require good credit history, like student cards. Further, the majority of credit card issuers report on all three major credit reporting bureaus no matter if you used the card or not this month.
- Personal loans: Some creditors will agree to provide loans to consumers with a poor credit score but higher interest rates. Otherwise, you can apply for a secured personal loan, but you’ll have to put up collateral first. This collateral gives confidence to lenders that if you default on your loan, they will take your collateral.
- Being an authorized user: If for whatever reason, you don’t want or cannot open your own credit card account, you can become an authorized user on a relative’s or a friend’s account that trusts you. This way, you can make purchases with the main user’s credit line, but only the main user will be responsible for paying. If the primary user makes full on-time payments and you both keep a low credit utilization rate, your credit scores will improve.
Are credit builder loans worth it?
Using a credit builder loan is a good method for those willing to spend a few hundred dollars on improving their credit scores.
This type of loan is not a way to earn money. Its only purpose is to improve the consumer’s credit score.
Taking into account that you’ll have to pay interest rates, you’ll probably lose a few dollars using a credit builder loan. However, the improvement of your credit score may totally worth it. A better credit score can help you find a job or rent a house easier and faster, especially if you are credit invisible.
Last but not least, if you’re planning to get a bigger loan (like a mortgage or an auto loan) in the future, you can save thousands of dollars on interest rates with a good credit score. Thus, the sooner you’ll start to work on your credit score, the better your financial life will be.
Once you have established yourself with solid payment history, it would be smart to apply for new credit with an unsecured card. This will help you to start building your credit.
Credit Builder Loans FAQs
You’ll usually lose less than $100. Of course, you have to calculate the interest rate and the fees (if any). Also, this depends on the size of the loan and if your account is interest-bearing. This information will also be on your closing statement. If it is, you should deduct those earnings from the interest rate’s amount, and you’ll find how much money you’ll lose. On the other hand, a higher credit score can save you thousands of dollars in interest rates later in your life.
First of all, they have nothing to lose because you’ll get the money only when you fully pay your credit builder loan. In addition, they earn money by charging interest rates and keeping consumers as customers.
No, it’s not a wise decision. This is because credit builder loans help you report monthly on-time payments. The more on-time payments you have on your payment history, the better your credit score will be. It also depends on the contract you signed with your creditor, but you can often pay it faster if you need to do so.
The most important tip you should follow is making full-on-time payments every month for credit builder loans and credit cards. If you’re against using credit cards for making purchases, you can use a credit builder loan. Credit cards are more likely to report on all three credit reporting bureaus and more frequently.
Building credit is not a quick process, but with steady progress and positive credit history, you will raise that bad credit score and get a better financial situation.
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