What Is a Credit-Builder Loan?
Credit-builder loans can help you build your credit score,
and they don’t require credit to start with.
They’re
not widely advertised and are generally offered by smaller financial
institutions, such as credit unions and community banks.
The purpose, as their name suggests, is to help people achieve credit
respectability.
Financial
institutions would like to see you succeed. After all, if you become a
customer, you’re more likely to make money for them in the future. To make sure
it doesn’t get burned on the loan, the lender will set strict limitations.
Think of it as training wheels for credit.
Credit-builder
loans go by many names, such as the catchy “Fresh Start Loans” or “Starting
Over Loans.” If you’re looking to rebuild credit with an installment loan, ask your
bank or credit union about secured personal loans designed to help people who need to
help build credit.
Secured credit cards have long been suggested as a means of
credit building — and they can be very effective — but you first have to have
enough money to pay the security deposit.
If
you have an income but can’t pay a deposit for a secured credit card,
credit-builder loans offer a way around that hurdle.
How credit-builder loans work
You
apply for the loan, whether you have bad credit or no credit, and you are
approved, but there’s a safety net for the lender. The money you borrow is
deposited in a savings account — one that you cannot access until you have
fully repaid the loan.
If
you pay the loan as agreed, the financial institution promises to send a good
report to the credit bureaus. A 2013 study showed an average improvement of 35 points with six months of on-time payments
for loans as small as $100.
At
the end of the loan term, you get the money — and likely an improved credit
score.
But
be sure to pay on time. If you miss payments, that negative
information would also be reported. The financial institution doesn’t take a
big risk when it lends to you, because it can reclaim the money if you
don’t hold up your end of the bargain.
If
you’re looking for a credit builder loan and your credit union or community
bank doesn’t offer them (or even know what they are), you might try a Community Development Financial Institution.
These organizations exist to help lower-income communities, and there are about
1,000 of them in the United States. Government grants and other incentives make
these small-dollar loans more attractive to financial institutions.
Online
lenders include Self Lender, which offers $1,100
loans repaid over a year at $100 a month. At the end, you get $1,100 and a
credit score with a year of on-time payments.
How secured installment loans work
You
don’t have to be low-income to have crummy credit or a need to rebuild. If you
have money in the bank, you may have another option for an installment loan: a
share- or certificate-backed loan.
In
that case, a deposit you already have at the financial institution is the
collateral, and that money is frozen until the loan is repaid (or it may be
incrementally thawed, as the loan is repaid). So if you have funds on deposit
at a small bank or credit union, it may be worth asking if you can borrow
against them to help re-establish credit.
You may have other options for building credit
Secured
loans such as credit-builder loans tend to be a good deal because the
collateral reduces risk for the lender and greatly reduces the interest rate,
which is typically well under 10%. The catch, of course, is that you don’t get
the money until the loan is repaid.
If
you are trying to build credit and need the proceeds of a loan immediately (for debt consolidation, for example),
you will probably need to take an unsecured personal loan. That means
the lender has no collateral, just the strength of your credit history, to rely
on. If your credit is damaged or thin, you’ll pay higher interest rates,
sometimes as much as 36%, which tends to be the ceiling with most lenders.
Some lenders
who will grant you unsecured personal loans without checking your credit at
all, but those installment loans are much more like payday loans. The
lenders don’t check your credit, but they also don’t report to credit
bureaus unless you default. And the loans carry interest rates that can easily
reach 300% or higher.
Source : Bev O’Shea is a staff writer at NerdWallet, a
personal finance website.