Credit builder loans are a tool used by people with weak credit profiles to establish payment history.
They are small loans offered by banks, credit unions and online lenders, designed for people with limited or no credit history.
As a result, these loans have additional protections for lenders. In particular, you do not have early access to the loan amount. Instead, you have to make monthly payments first, and once you’ve essentially paid off that amount, you’ll receive the lump sum.
How do credit builder loans work?
When you take out a credit builder loan, your lender will move the loan amount (usually $300 to $1,000) into a locked savings account.
Like a traditional loan, credit builder loans require you to make a fixed monthly payment to the lender, and this monthly payment includes an interest rate or the loan’s annual percentage rate (APR).
Let’s say you take out a credit builder loan of $600 for one year with a 10% APR. Your monthly payment would be $52.75 ($50 principal, plus interest).
After 12 months, you’ll receive that $600 you saved and have one year of positive payment history reported to the major credit bureaus. With some lenders, you may also retain a portion of the interest.
Credit builder loans are not typically offered by larger banks, so you may have to shop around to find them. Your options may include community banks and credit unions, as well as online lenders.
The loan term is generally between 6 and 24 months, according to the Consumer Financial Protection Bureau (CFPB).
Since credit builder loans are secured, the lender can simply close the account if a borrower stops paying. According to the CFPB, “borrowers are protected in the sense that they may not end up with a lasting remaining balance.”
How much does a credit builder loan cost?
The main cost of a credit builder loan is interest, which borrowers pay on a monthly basis. Lenders currently advertise online rates ranging from 5% to 15% or more.
If you’re planning to take out a credit-building loan, it’s a good idea to compare several options to find the best rate.
In addition to interest, credit builder loans may incur origination fees. There may also be payment processing fees and late fees, depending on your loan.
Is it worth using credit building loans?
Credit builder loans can be effective, especially for people who need to build credit from scratch. If you’re looking to repair bad credit after a major financial discrepancy, such as bankruptcy, you may also want to consider a credit builder loan.
When you make on-time payments for a credit builder loan, that history will be reported to the three major credit reporting agencies (Equifax, Experian, and TransUnion). Within a few months, you should start to see your credit score increase.
Lenders want proof that you don’t overspend and can pay your bills on time, and if you don’t already have an established line of credit, you may have trouble proving that you’re a reliable borrower. This is where credit builder loans come into play. Payment history makes up 35% of your FICO score, so making on-time payments on your credit-building loan can put you on track to qualify for better loans and financial products with lower rates.
Risks of a credit builder loan
The biggest risk of a credit builder loan is the consequences of missed payments. If you don’t pay your loan on time, your credit score could take a hit, just like if you miss any other type of loan payment.
Also, if you are paying off debt, this should be your top priority. Instead of adding a monthly payment for a credit builder loan, consider focusing on your debts.
Credit Cards vs. credit building loans
Credit builder loans aren’t the only way to improve your credit. While credit cards have their risks, many people choose to start their credit journey with an initial credit card (such as a secured credit card) rather than a loan product.
Opening a credit card and managing it responsibly—that is, using no more than 30% of your credit limit and paying off the balance in full each month—is also an effective way to start building credit if you don’t want to take on any loan obligations . .
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