Understanding Credit Builder Loans
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Consumers looking to establish or improve their credit have an option they probably haven’t heard about: credit builder loans. Not widely advertised, credit builder loans are specifically designed to help consumers demonstrate a consistent and on-time payment history.
If you’re looking to increase your credit score and prove your creditworthiness to potential future creditors, taking out a credit builder loan could help you achieve both.
What is a credit builder loan?
Credit builder loans are exactly what they sound like: loans meant to build one’s credit. They’re geared toward consumers who have little to no credit history or have adverse marks. These low-credit consumers can take out a credit builder loan and add a satisfactory account to their credit report, which will hopefully increase their credit score over time.
Credit builder loans are similar to traditional personal loans in that they are paid in installments and the borrower pays interest. But other than that, they are quite different.
Instead of the loan funds being available for immediate use, the amount borrowed is held in a separate interest-bearing savings account or certificate of deposit (CD) until the loan is paid in full. Once the loan is paid, the funds are yours to use in any way you wish.
In a way, these loans are almost like forced savings. In fact, some lenders that offer credit builder loans refer to them as credit builder savings programs.
Lou Cannataro, the founder of Cannataro Park Avenue Financial in New York, describes credit builder loans as “loans with training wheels.”
“[It’s] a small step that provides the ability to build credit,” he explained. Cannataro said they are a useful tool for consumers who need to get back on track after making credit mistakes or for those just starting out.
“In the end, you’ll have serviced a loan, and on the credit report it will show you’ve taken out a loan and paid it back,“ he said.
However, these loans do not guarantee an increase in credit score or improvement in credit history. They only provide the potential to do so. As with any other loan, it is the borrower’s actions that will dictate how the loan affects their credit.
Features of credit builder loans
The exact terms of credit builder loans vary by lender, but some common features include the following:
A high credit score isn’t needed. Lenders that issue credit builder loans typically don’t require a high credit score, since the point of the loan is to establish or improve it. However, you will still go through the lender’s approval process which may include checking your banking history or other consumer reports so the lender can assess your ability to repay the loan.
Short loan length. Credit builder loans often have short repayment periods, typically 12, 18 or 24 months.
Small loan amounts. These loans are for small amounts, usually under $3,000.
Funds are held in a separate account. The amount you borrow is issued immediately but locked in an interest-bearing savings account or CD until you’ve repaid the full amount.
The loan is reported to credit bureaus. Your lender should report the loan to the major credit bureaus. The loan and its payment history, both positive and negative, will become a part of your credit history and affect your credit score. Cannataro said these loans aren’t identified as credit builder loans on your report and appear just like any other loan.
Funds are released when the loan is paid off. Once all payments are made, the funds are released to you, and the loan is considered paid in full.
Fees and fine print to watch out for
Although credit builder loans can help improve your credit, Cannataro said consumers should be wary of the fees involved. “Essentially you’re paying for a service that improves your credit,” he said. If you’re considering a credit builder loan, do your due diligence and beware of the various fees involved.
Upfront fee. Many lenders charge some sort of fee upfront, whether it’s an application fee, administrative fee or processing fee. In many cases, this charge is nonrefundable.
Interest rate – The interest rate lenders charge varies and is based on the terms of each loan. When comparing multiple credit builder loans, look at the APR to determine the actual cost of borrowing.
Earned interest – While the amount of interest earned will be nominal, given that the loan amounts are small, it makes sense to consider the interest rate the funds will earn while it’s in the savings or CD account. Some lenders only return 50 percent of the earned interest to you at the end of the loan term.
Fine print – Each lender has different terms and conditions associated with their credit builder loan. For example, some lenders require every scheduled payment to be made on time for the earned interest to be credited to you.
How to find and apply for a credit builder loan
If you are considering applying for a credit builder loan, follow these steps to identify the best option for you.
Determine whether you’re prepared to take on new debt
Before searching for a credit builder loan, assess whether you can handle more debt. Even though the loan amount and the monthly payment will likely be less than a typical personal loan, it is still additional debt. Carefully consider the implications of adding to your debt load and monthly payments.
Though credit builder loans aren’t widely known, multiple lenders offer them. Some institutions may refer to them as credit builder programs.
Credit unions and community banks – The majority of lenders that issue credit builder loans are smaller financial institutions such as credit unions or local community banks. If you already have a relationship with your local bank or credit union, inquire if they offer credit builder loans, or seek out an institution in your area that does.
Online Lenders – Some online lenders, national credit unions and banks also offer credit builder loans and programs. Some products are limited by geographical location, so be sure the check the availability of the loan in your area.
For example, Self Lender currently offers credit builder loans from $525 to $1,700 with monthly payments ranging from $25 to $150.
Review terms and apply
Terms vary by lender so be sure to compare the terms to determine which credit builder loan is the best for you. Consider the interest rates, both earned and paid; the loan amounts offered; the repayment period; all associated fees; and any other stipulations of the loan.
How to manage your new loan
Because the purpose of the loan is to build or improve your credit history, it’s crucial that you carefully manage your repayment. Keep the following tips in mind.
Pay on time
Cannataro said consumers who take out credit builder loans must stay focused and have a plan in place to make their payments on time since the goal of the loan is to show a favorable payment history.
“If you miss a payment or pay late, you’ll kill your credit,” he cautioned. Remember, the lender will be reporting all activity on this loan to the credit bureaus whether it’s positive or negative, so don’t risk missing a payment. Setting up autopay directly with the lender or through your bank’s bill pay service will guarantee that you pay on time every month.
Pay the loan as scheduled
Even if your loan doesn’t have a prepayment penalty, you may want to stick to the scheduled payment amount and length of the loan. Paying extra or early will shorten the life of the loan and reduce the positive impact on your credit history.
Check your credit
As the loan matures, Cannataro said consumers should look at their credit reports to make sure the loan is there and has been accurately reported. Likewise, he recommended that consumers check their credit at the end of the loan period.
Other options for building your credit
In addition to the credit builder loan, these options might also help you improve your credit.
Secured loans are tied to an asset or account that you have funded before you take out the loan. This serves as collateral if you default.
Secured credit card
Another option is a secured credit card. You provide a certain amount of money upfront that is deposited into an account, and then you are given a credit card with a limit equal to that amount. Secured credit cards often come with a lot of fees which can eat into the available balance, so be sure to review the terms carefully.
Check your credit report for errors
Cannataro suggested a simple and often overlooked way to improve your credit: Review it for errors. “There could be a loan on there that’s not yours, so make sure your credit history is accurate,” he said. Consumers are entitled to one free credit report from each of the three major bureaus annually at AnnualCreditReport.com. If you do find an error on your credit report, click here to view ways to dispute it with credit bureaus or data furnisher’s
Pay your bills on time
According to the FICO algorithm, 35 percent of your credit score is determined by your payment history, to improve that part of your score by making your payments on time.
If you decide to move forward with a credit builder loan, decide ahead of time that you will demonstrate an impeccable payment history, and use the loan as a way to develop better money management habits. The goal, Cannataro said, is to take the training wheels off eventually. Once you do, you’ll never look back.