Building credit is a vital tool to create financial well-being. A low credit score makes it more expensive to borrow money. A high credit score can help you buy a home, pay back your debt sooner, and even help you qualify for lower car insurance in some cases. But how do you get there? A credit-builder loan may help you.
Overview of Credit-Building Loans
A credit-builder loan is designed to help people with limited or no credit history establish a positive credit history over time. Unlike traditional loans, credit-builder loans do not require a good credit score to be approved. Instead, they provide an opportunity to access credit that can be used to demonstrate creditworthiness and improve one's credit score.
To evaluate your creditworthiness and ability to repay the loan, the lender will require some personal information, such as your employment history, income, and the balance of your savings and checking accounts. Some lenders may have minimum income requirements or other qualifications to qualify for the loan. This information will help the lender assess your financial situation and determine if you have sufficient income and resources to repay the borrowed money.
How Credit-Building Loans Work
Credit-builder loans, sometimes called "fresh start loans," are not as commonly known as other loans, like secured credit cards. However, many smaller banks, including local credit unions and community banks, offer these loans.
With these loans, the money you borrow is placed into a bank account while you pay it back. Your payments are then reported to the credit bureaus (or at least one of them). Over time, you are building a positive history of making on-time payments. The establishment of the loan on your credit report, along with on-time payments, can help to build your score.
Some of these loans do not allow you to access the borrowed funds until you have paid the loan in full. That means there is very little to no risk to the lender, but they give you the financial incentive to make timely payments. Once the loan term ends and you have paid off the total amount, those funds are accessible. They can be an excellent tool to help you build an emergency savings account.
Some of the benefits of using a credit-building loan include the following:
- You do not have to have a proven credit history – or any credit–to qualify for the loan. That makes them easier to obtain if you have income.
- Making payments on time can help you to build your credit score, proving to other lenders that you can be a responsible borrower.
There are a few drawbacks to these loans as well.
- Most will have fees. This could include account set-up fees along with interest rates. Interest rates vary significantly between lenders.
- You cannot touch these funds until the loan is paid back. If you fail to pay, you may not get the funds you've paid into the loan.
Tips for Using a Credit-Building Loan
If you plan to use a credit-building loan, there are a few things to do to ensure you get the most benefit out of them:
- Find the best option with the lowest interest rates and ideal terms. The key here is not to seek out the most significant loan but one that is affordable for you to easily make monthly payments on.
- Be sure to make those payments on time every month. This is the sole key benefit of these loans, and having steady, on-time payments can help you make the loan worthwhile.
- Turn to several lenders to find one that can offer you a credit builder loan, including credit unions, local community banks, and some online lenders. Not all lenders advertise these on their websites.
Alternatives to Credit-Building Loans
While credit-building loans can be a good starting point for some people, they are not the only option available to you to build your credit. Secured credit cards are an alternative. Here, you will make a deposit that establishes your line of credit and can then borrow and pay back the funds over time while the lender reports your payment history to the credit bureaus.
If you have some credit, you may qualify for other loans. For example, a car loan or a retailer credit card may offer a good stepping stone to start building your credit score over time, although they may have higher interest rates and fees than credit-builder loans. Be sure you check your credit report to have an accurate idea of your ability to qualify for these loans.
Published July 2023