What is a Credit Builder Loan?

What is a credit builder loan?
What is a credit builder loan and how does it work?

A credit builder loan is a type of loan that is designed to help people with little or no credit build credit not excluding those with a damaged credit score. A good credit score makes it getting approval for a credit account easier for you and gives you the edge to access better rates and terms.

It does not require a good credit score to qualify for it. However, they do require that you have enough income to make payments.

A credit builder loan is quite different from the traditional loan in that when you borrow a traditional loan, you are being given the loan and subsequently pay it back with interest. But when you borrow a credit builder loan, the borrowed money is not given to you but kept in a bank account while you make payments and build credit.

It is a great credit-building tool as it helps fix bad credit and help people establish credit. Let’s look at how credit builder loans work and how to manage a credit builder loan effectively and get the most out of it.

How does Credit Builder Loan Work?

Credit builder loans are also referred to as “Fresh start loans” or “Starting over loans”. Unlike traditional loans, they’re not widely advertised. And they’re generally offered by smaller financial institutions, such as credit unions and community banks.

When you apply for a credit builder loan and it gets approved, the amount you borrowed is kept in a bank account while you make payments to repay the loan. And until you repay the loan, you can’t have access to the money.

In a nutshell, you’re able to build savings and your credit same time. This also helps the lender that’s taking the risk to be on a safer side if you have a bad credit score or have no experience with credit.

Since your credit score is built from information in your credit reports, which the three major credit bureaus compile, your loan payments are reported to at least one credit bureau. As long as you make on-time payments, having your credit reported helps build your credit.

When you get a credit builder loan, one thing you should always do is make payments to have a good bill payment history. This is very crucial in building your credit score as the two major scoring models FICO and VantageScore pay the most attention to your payment history.

How to Manage a Credit Builder Loan?

Here are 4 ways to manage your credit builder loan.

  1. Choose the right type of credit-builder loan
  2. Ensure to make payments on time
  3. Monitor your credit score
  4. Spend your loan proceeds plus any interest wisely

Choose the right type of credit

Be on the lookout for the one with the payment you can comfortably afford. Do not stretch your budget as that will only increase your risk of missing payment and hurting your credit score. Your main goal of applying for a credit builder loan is to build credit, do not ruin that by choosing a loan amount you can’t be able to manage. We strongly recommend you choose a manageable loan amount and a term no longer than 24 months. Choose a loan that reports payments to all 3 major credit bureaus.

Ensure to make payments on time

As already stated, payment history is one of the factors that affect credit that major scoring companies pay the most attention to. When you make on-time payments, it is recorded in your credit report which helps improve your credit score. On the same hand, if you make late payments, it is also recorded on your credit report and can damage your credit score.

Monitor your credit score

Always check your credit score from time to time to see if there’s an improvement or not. Watch the overall trend of your score and don’t obsess over tiny movements.

Spend your loan proceeds plus any interest wisely

When you’re done repaying the loan or at the end of your loan term, you get the money and good enough a better credit score. Use that money as an emergency fund, if possible. Having a few hundred dollars kept can save you from unexpected expenses that otherwise might lead to missed payments or debt and score damage.

Things to Consider Before Choosing a Credit Builder Loan?

  1. Administration fee: This is the fee charged by the lender to the potential borrower for processing and underwriting an application loan. Consider if you’ll incur an account set-up fee, usually $8 to $25.
  1. Loan size: Before choosing a credit builder loan, consider how much money you can comfortably put into a savings or CD account (without touching it for six to 24 months.)
  2. Monthly payment: remember that the smaller the loan, the lower the monthly payment and vice versa. Before choosing a credit builder loan, you must consider how much you comfortably afford to pay every month.
  3. Annual Percentage Rate (APR): Credit builder loans incur interest at a fixed rate, generally 5% to 16% depending on the size of the loan and the lender, so look for the lowest rates. For instance, Digital Federal Credit Union charges a low 5% APR while Self charges up to a higher 16% APR.
  4. Whether you’ll receive interest charges back: Some lenders such as 1st Financial Federal Credit Union may refund you a portion of the interest charges you paid. 1st Financial credit Union refunds 50% of interest after you make on-time payments.

Where to Find a Credit Builder Loan?

Credit builder loan is basically offered by credit unions and community banks. But there are also a couple of places you can get a credit builder loan. Here’s a list of where you can find a credit builder loan.

  1. Credit unions or community banks
  2. Community development financial institutions
  3. Lending circles
  4. Online lenders

Credit Unions or Community banks

One way to find a credit builder loan is to search online for a “credit builder loan.” Credit builder loans are available at credit unions or community banks nearby. Credit unions do have membership requirements that range from living in a particular county, working for particular companies, worshiping in a certain church, or making a small charitable donation. And for sure, they may offer the lowest interest rates.

Community Development Financial Institutions

If your credit union or community bank doesn’t offer credit-builder loans, you may opt for a community development financial institution. They are about 1,000 of them in the United States. These organizations exist primarily to help lower-income communities.

Lending Circles

A credit-building plan through a lending circle is a practice that can be used among families or friends. The nonprofit Mission Asset Fund runs a lending circle program where participants get interest-free “social” loans, with payments reported to credit bureaus. Although availability is limited.

In lending circles, about 10 participants each agree to put in a certain amount per month, and the money goes to one person, rotationally, each month until everyone has received a pot of money.

Online Lenders

Many online lenders offer credit builder loans. A simple search online can help you find them.

Note: Every lender is licensed in every state though. So you must find out if they’re licensed in your state.

How much does a credit builder loan cost?

Generally, credit builder loan cost varies across lenders. Below are the things that contribute to the cost of a credit-builder.

The annual percentage rate (APR): This is the amount your lender charges you to borrow the funds. An APR of less than 10% is common with credit-builder loans, but some have higher rates.

Interest payments: Some lenders offering credit-builder loans may keep part of the interest you pay, others keep all the interest you pay, giving you only the remaining balance at the end of the loan term.

Application fees and costs: Lenders may charge an application fee for the loan or charge late fees if you don’t pay on time.

The loan repayment term: The shorter your loan term, the less interest you’ll pay while the longer your loan term, the more interest you pay. Simple mathematics right?

Size of Loan: You don’t want to borrow too little or too much. When you borrow a larger amount of money, it could take you longer to pay back, which means paying more in interest. 

Is a credit builder loan a good idea?

Credit builder loan is a good idea for those who are willingly part with their few hundred dollars temporarily and manage their loan responsibly to build their credit. Though considering the interest, you won’t be able to get your whole money back but your credit score will improve greatly. So credit builder loan is a good idea.

Will a credit builder loan hurt my credit?

A credit builder loan can build your credit and can as well hurt your credit. For instance, when you make late payments or miss payments, it’s all part of your credit history that is being reported by your lender to the credit bureaus and that could hurt your score pretty much. Because your payment history makes up 35% of your credit score.

Conclusion

Credit builder loans are good options for building your credit if you have like a few hundred dollars you can temporarily part with to build your credit score by managing your credit responsibly.

Although it’s a great credit-building tool but is not our top pick for building credit. Below are other credit-building tools you may want to consider when building your credit score.

  1. If you have money in the bank, you may have another option for an installment loan
  2. If you have a friend or relative who has excellent credit, you could ask them to add you as an authorized user on a credit card.
  3. Another great option to building your credit is through a Secured credit card. Secured credit cards require an upfront deposit, typically starting at $200.

But if you’re unable to use any of these alternatives listed above, you can proceed with the credit builder loan. Your aim should be to build your credit at a low cost. It’s important you review the terms and conditions of the loan and choose the lowest-cost option so you can build credit at a minor cost.

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