What A Credit Builder Loan Is And How To Use It Wisely
Without much credit history, applicants for credit cards can face a common Catch-22 when they’re denied credit: They can’t open a credit account until they have a credit history.
And they won’t have a history of using credit if they don’t have a credit card to use.
People just starting their financial lives can usually be approved for a credit card if they have a good job. But those without much income can have a harder time establishing credit, which can eventually make it easier to get home and auto loans, and to get rewards credit cards.
Luckily, there are a few ways to start a credit history, which is a record of how long you’ve had credit accounts and if you’ve paid them on time. Credit history is the biggest factor in determining a credit score.
One option is a credit builder loan. Being approved for one doesn’t require having a credit history. In fact, credit builder loans are primarily designed to help credit newbies establish a credit history so they can be approved for credit cards and other forms of credit.
How A Credit Builder Loan Works
It’s going to sound backward to what a regular loan looks like, but here’s how it works:
Instead of receiving the loaned money upfront, the money you’re borrowing in a credit builder loan is deposited into a savings account or CD for you that you can only access when your loan is repaid.
It sounds odd, but that’s how it works: You receive the loan money after you’ve repaid the loan. Not before.
The loan must last at least six months, which is the minimum amount of time the credit bureaus require credit accounts to be open for them to count toward a credit score.
You must make consistent, on-time payments on the loan during those six months for the credit builder loan to positively affect your credit score.
And that’s the main reason to get a credit builder loan: To establish a credit history and improve your credit score. Not making timely loan payments defeats the purpose of the loan.
Downsides Of Credit Builder Loans
These loans are typically only for $300 to $1,000. Such a small loan can be easier to repay, but the problem is that you won’t get that loan amount until you’ve repaid it. In essence, you’re prepaying the loan before you get the money.
Like a secured credit card, the bank is holding the money it will pay you as collateral.
Before taking out a credit builder loan, know what your monthly payment will be. Make sure it’s an amount you can afford. The larger the loan, the higher the monthly payment.
The loans typically require paying a set-up fee of $9 to $25.
And, of course, you’ll pay interest on the loan. It will usually be at a fixed rate, between 5% and 16%. Some lenders may give you part of the interest charges back if you make on-time payments.
Where To Get A Loan And How To Use It
Smaller financial institutions such as credit unions, community banks and online lenders are most likely to offer credit builder loans.
Compare lenders and the options and terms that each lender offers.
The best way to use a credit builder loan is to not use the money at all. Remember, the purpose of the loan is to build your credit history so that the credit bureaus can see that you have a good record of paying back a loan. Lenders such as credit card providers will then be more likely to offer you credit.
So instead of immediately spending the money you get once you’ve paid off the credit builder loan, set it aside or use it for an expense you already planned.
If you can, save money for repaying the credit builder loan before you apply for the loan. That way you’ll be assured of repaying the loan and won’t be in debt.
Since your ultimate goal is to establish a credit history so you can get a credit card, and later use a good credit score to get a car or home loan, there are other ways to get your credit history started.
One is to become an authorized user on a family member or close friend’s credit card account. Both you and the main user are responsible for repaying any charges you make, so make sure you can afford anything you buy as an authorized user.
Another option is to open a secured credit card. These cards allow you to deposit money and receive a credit amount equal to the deposit. You use the card just as you would any other credit card, but only up to the deposit amount that’s used as collateral.
College students and others who don’t normally have much of a credit history can also apply for credit cards aimed at them. Ask your bank what types of credit cards it offers customers who don’t have much of a credit history.
And if all of that fails, then maybe consider a credit builder loan. Use it wisely and your credit history and eventually your credit score, should be much better for it.