Borrowers with bad credit face a real Catch-22 when it comes to rebuilding their credit. They need a chance to rebuild their credit history, but the only way to do that is to get credit and then use it responsibly. But very few lenders will be willing to extend it to them because they have shown that they cannot make their payments on time, or at all in some cases. A credit builder loan can help solve this problem.
Written by Mark P. Cussen, CMFC.
Updated December 12, 2021
If you have no credit history or poor credit history, building or rebuilding your credit score can be challenging. You may have to settle for high-interest credit cards, a subprime mortgage, or limited checking account options. Lenders will likely also charge higher interest rates for auto loans and personal loans.
The bottom line: Having bad credit or no credit is very expensive. So, what can you do to turn things around? One option is a credit builder loan. This can help you improve your credit and eventually qualify for loans with lower rates.
This article will cover what credit builder loans are, how they can help your credit score, and what to look for if you want to take out one of these loans.
What Is a Credit Builder Loan?
A credit builder loan is a special loan some financial institutions offer to help borrowers improve their credit scores. Credit builder loans are always secured loans. This means the borrower pays for the loan upfront.
If you have bad credit and want to improve your credit, you face a Catch-22. You need to get and use credit responsibly to improve your credit score. But very few lenders are willing to extend credit to individuals with low credit scores. Having a low credit score signals to a lender that it’s risky to lend money to you. It reflects that you haven’t made past payments on time. Or maybe you have no credit history, and lenders don’t have enough information to know whether you will repay a loan or not. A credit builder loan helps solve this problem.
How Do Credit Builder Loans Work?
Credit builder loans are secured loans backed with the borrower’s own money. Once the loan is approved, the collateral is deposited into an FDIC-insured bank account that the lender controls. It is usually invested in either a money market mutual fund or a certificate of deposit (CD) that will mature when the loan is due to be repaid. Credit builder loans usually have a term from six months to two years. Loan amounts range from $300 to $2,000 or more.
By paying the loan collateral in cash upfront, you can then essentially borrow your own money. As you make on-time payments, the lender reports them to the credit bureau. These count as real payments on your credit history. Over time, they help boost your credit score. Plus, at the end of the loan term, you’ll get your loan balance back. So credit builder loans also act as a form of savings account.
For example, let’s say you get a credit builder loan for $2,000. You pay the $2,000 to the lender who puts it into a secured account. You can then begin borrowing it from the lender. You will make monthly payments on the principal and interest of the debt—the amount you borrowed— until you repay it in full. Then the lender will refund the loan amount.
If you miss payments or default on the loan, the lender can use the money they’re holding to cover the balance due. This is what makes the loan less risky for the lender. But if you make all the payments on time, the lender will report this to one of the three major credit bureaus: Experian, TransUnion, or Equifax. These on-time payments are good for your credit history and can help increase your credit score.
Credit builder loans are great, but there are some disadvantages. For one, you have to come up with the loan balance upfront. If you’re struggling with your finances, this may be difficult. Second, you won’t have access to the loan proceeds until you’ve fully repaid the loan. But if you can clear these hurdles, you can start to rebuild your credit and get a new lease on your financial life.
How Is a Credit Builder Loan Different From a Traditional Loan?
With a traditional loan, the lender gives the proceeds to the borrower upfront. The lender takes on the risk of not getting their money back if the borrower defaults on, or doesn’t repay, the loan. Credit builder loans differ from traditional loans in that the borrower gives the lender the loan proceeds upfront. The lender then holds the loan proceeds, which the borrower can draw on or borrow from overtime.
Credit builder loans are less risky for lenders because the borrower has to come up with the loan collateral in cash before the loan is made. The lender keeps the collateral proceeds in an account where they can access it if it becomes necessary. For this reason, the lender is willing to loan the borrower money even though they have either no credit history or bad credit. Some lenders won’t even run a credit check on the borrower if they have enough income to make the loan payments.
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Will It Really Improve My Credit Score?
About a third of your credit score is based on your payment history. If you can stay current on all of your payments (not just your credit builder loan payment), then your score will eventually start to improve. So, yes, credit builder loans can be an excellent way to rebuild your credit score over time, as long as you always make your payments on time. If you start making late payments or miss payments on your credit builder loan, you can hurt your credit score more than ever. Don’t take out one of these loans if you aren’t certain that you can make the monthly payments.
What Should I Look for When Shopping for a Credit Builder Loan?
If you’re thinking of getting a credit builder loan, it’s a good idea to shop around and compare interest rates and fees. The annual percentage rate (APR) for credit builder loans can range from 10% to 15%, so be prepared to pay a higher interest rate at the outset. But if one loan has a much higher APR than others you’re looking at, you may want to eliminate it from your search.
Many credit builder loans also have fees. Lenders might charge an application fee, an annual or monthly fee, an early payoff fee, or late payment fees. Take these into account when choosing a lender. These fees can often substantially impact the true APR, especially if they are charged for one late payment or missed payment. If a loan’s APR is 10%, but it charges a 1% fee for all late payments plus a 2% outstanding balance fee, then the real APR may be closer to 14%. But these terms will always be more generous than terms for payday loans or other forms of fast credit.
Finally, look at what your minimum and maximum loan payments may be and how much they’ll cost you in the long run when including interest. The loan amount will determine your loan payment in most cases. Some lenders are there to try and help you, while others are there to squeeze as much money out of you as they can. Building credit is often a numbers game. Shop carefully and run the numbers for all of the offers you get so that you don’t end up worse off than you were before.
What Financial Institutions Offer Credit Builder Loans?
Unfortunately, not all financial institutions offer credit builder loans. In most cases, you will see regional banks, community banks, local banks, and local or regional credit unions offering these loans. Some federal credit unions and other lenders looking for new business may also offer these loans, though they may charge higher interest rates.
Some nonprofits or community development financial institutions may also be willing to take a chance on a down-and-out borrower looking to improve their credit score. But they may impose a lower credit limit than an unsecured online lender would allow. Hope Credit Union and BMO Harris Bank are two examples of such lenders in Kansas, but there are many more. Do a Google search to find potential lenders in your state. Several different lenders will likely come up, so be sure to do your research. Make sure that they are reputable and proceed accordingly.
Building good credit is important for your financial future. Credit builder loans are special loans available to those who have bad credit or no credit. They require you to come up with a security deposit for the loan upfront, then you’ll make payments on the balance until the loan is paid off. This helps you show a stable payment history, which improves your credit score. While these loans may come with fees and interest, they can save you money in the long run by lowering interest rates on future loans. Consult your financial advisor or a nonprofit credit counselor for more information on how you can use a credit builder loan to improve your FICO score and credit report.