How Credit Builder Loans Work

A good credit history opens the door to better interest rates, more loan approvals, and more valuable credit card rewards. But getting that good credit history isn't always easy. If you don't have any credit accounts in your name, or if you've been irresponsible with money in the past, you may have trouble finding lenders who are willing to give you a chance.

Fortunately, there are resources that those with poor or no credit can use to begin establishing a good credit history. One of these is the credit builder loan. Here are a few things you need to know before applying for one.

What's a credit builder loan?

Credit builder loans are small loans -- usually ranging between $500 and $1,500 -- that you take out with the sole intention of build your credit. In other words, they're not meant to finance any particular purchase. As with traditional loans, you'll have to pay some interest on the balance. This could be anywhere from about 7% to 22%, depending on the lender. But unlike traditional loans, you don't get the money you request right away. Instead, the lender puts it in an account where you cannot touch it until you pay off the full balance of the loan. In exchange for the money you pay in, the lender will report your payments to the three credit bureaus each month, and thus your regular, on-time payments will improve your credit score.

Because the lender isn't technically loaning you money, credit builder loans carry no risk for the lender. This makes them easier to get than other types of loans, even if you have a bad credit score (usually regarded as around 630 and below). However, you do have to show a regular source of income in order to get approved. The lender will want to make sure you'll be able to afford the monthly payments.

Credit builder loans are usually available through smaller financial institutions, including community banks or credit unions. Some nonprofit organizations offer them as well. They're not always called credit builder loans, though. You may see them referred to as "Fresh Start" loans or something similar. Contact the financial institutions in your area to see whether they offer these types of loans.

Is a credit builder loan right for you?

A credit builder loan is a good way to build your credit, but it's important to make sure you can afford it first. Look at how much the monthly payments will be and ensure you can comfortably afford them. It's not wise to take out a credit builder loan if it would strain your budget, because there's a chance you could fall behind on your other bills and hurt your credit score instead of helping it.

Keep in mind that you'll be forking over money that you may not get back for several months or even a couple of years, depending on the size of the loan and how much you repay each month. Also, you'll be paying interest that will most likely not be refunded to you at the end of the loan term. It's simply the cost of taking out this type of loan. That said, some lenders will refund you the interest charges if you make all of your payments on time.

Alternatives to credit builder loans

If a credit builder loan doesn't sound appealing to you, there are other ways you can build your credit. Credit cards are the most obvious. If you can't qualify for a traditional credit card on your own, see if a friend or family member will make you an authorized user on their credit card. This enables you to use the card as if it were your own, but the responsibility for payments still rests with the primary cardholder. The account will show up on both of your credit reports, though, and regular on-time payments can help boost your score.

A secured credit card is another option. These cards require a security deposit (usually at least $200) that is equal to your credit limit. That deposit acts as an insurance policy for the lender: If you fail to repay an outstanding balance, the lender can recoup its money by keeping your deposit. This low lending risk is what makes secured credit cards easy to obtain. Meanwhile, as with any other credit card, your payment history is reported to the credit bureaus each month, so responsible use will improve your credit score over several months. If you decide to close the account, your security deposit will be refunded to you.

If you're renting, you may be able to get credit for paying your rent on time. Talk with your landlord or management company and see if they'll report your payment history to the credit bureaus. If not, you may be able to report it yourself using an online rent payment service.

Credit builder loans are one way to build credit, but there are other options if you don't like paying interest without getting anything tangible in return. Whichever method you choose, however, it's important to pay promptly every month. If you miss payments, these credit building strategies could just as easily lower your credit score even further.

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