What is a Credit-Builder Loan and How Do They Work
A credit builder loan is a loan where the amount you borrow is held in a bank account while you make payments, thereby building credit history. Credit-builder loans don’t require a good credit score so people with bad credit, poor credit or no credit history can apply and get approved. Because the amount you borrow is held in a bank account as collateral, the financial institution lending the money to you has no risk because it could simply collect the money in the bank account if you were to stop paying. On-time loan payments are reported to the three major credit bureaus: Experian, TransUnion, and Equifax, and at the end of the loan term, the lender will return to you the loan proceeds plus interest, if applicable. Therefore, credit builder loans can help improve your credit over time and save money consistently.
Basics of a credit builder loan
Many lenders will not require a credit check for a credit builder loan. However, lenders may use your banking history or other underwriting criteria to determine whether they will approve you for a credit builder loan. You may also need to provide the following information:
- Employment information
- Paystubs or proof of income
- Account balances
- Outstanding loan information
According to the Consumer Financial Protection Bureau (CFPB), credit builder loans typically range from $300 to $1,000 in size and is repaid over 6 to 24 months. When choosing a loan amount for your credit builder loan, consider your income and ability to repay the loan. Choose a smaller amount if you’re on a tight budget. Remember, both on-time and late payments are reported to the credit reporting bureaus so if you fail to pay your credit-builder loan, it undermines your credit building efforts.
The amount of interest and/or fees you pay on the loan varies by lender. At the end of the loan, some lenders return the interest together with the amount you borrowed. When choosing lenders, be sure to understand any interest charges, APR, the total fees you pay, and lender policies about changing loan payments and returning the interest.
A credit builder loan is not for everyone. If you don’t have the money to spare and have bad credit, borrowing using alternative options like payday loans or a Possible loan could be a better option. With a loan from Possible, you can receive money as well as build credit.
Where to get credit builder loans
Credit Unions. Many credit unions have credit builder loans. You can apply online or in person at your neighborhood credit union. Credit union loan amounts range from $300 to $1,000, interest averages 10% and term can be 1 year. Repayments are reported to the credit bureaus and 50% of interest may be refunded at the end of the term.
Banks. Local, regional, and national banks offer credit builder loans to establish credit as one of their products. For example, Wells Fargo allows for a Wells Fargo certificate of deposit (CD) or savings account to secure a loan or line of credit that you borrow. Payments are reported to Experian, TransUnion, and Equifax.
Self Lender. Based in Austin, Texas, Self Lender works with multiple banks and offers a credit builder account based on a certificate of deposit (CD) backed installment loan. Customers open a CD with a bank through Self Lender and the bank extends a line of credit for the same amount. Payments when made are reported to the credit bureaus. Loan amounts, fees, and terms vary and there may be an origination fee.
Lending Circles. Certain community organizations facilitate peer groups that help those within the group build credit. The peer group decides on a monthly payment and loan balance. The loans are usually interest-free with no fees and each member of the peer group pays the same monthly amount to a central account. Each month, a member of the peer group receives a loan in the agreed-upon loan balance and payments are reported to all three credit bureaus. You can look up lending circles in your area at Mission Asset Fund.
Process for a credit builder loan
- Lender opens a savings account. Once the lender approves the application, the loan amount is set aside in a savings account for you. However, you will not have access to the account until you pay off the entire loan.
- You start making payments. You will usually make equal monthly payments for the term of the loan, which can be 6 months up to 24 months depending on the lender.
- Payments are reported to the credit bureaus. The lender will report your payments, whether on-time or late, to the three major credit bureaus: Experian, TransUnion, and Equifax each month. If you responsibly pay on time, you will build credit history and your score should increase. If not, your score may decrease, undermining the primary reason you are using the credit builder loan for.
- Interest is charged throughout. APRs range between 6% and 16% depending on the lender. The APR may be slightly reduced by interest you earn on the certificate of deposit or savings account. In addition, many lenders will return a portion of the interest back to you when the loan is repaid.
- Your loan term ends and the funds are returned to you. Once you have made all the payments on the loan, the lender will give you access to the certificate of deposit or savings account. You will be able to access the money for your own personal use.
Alternative to credit builder loans
Secured credit cards. A secured credit card requires you to place a refundable security deposit on your credit card. The refundable security deposit is the card’s credit limit and prevents you from spending more than you can repay on the credit card. Secured credit cards offer almost guaranteed approval because the issuer of the card uses the security deposit as collateral if you cannot pay your credit card bills and the outstanding credit card debt. Payments for secured credit cards, similar to unsecured credit cards, are reported to all three credit bureaus.
Possible loan. Possible has installment loans up to $500 that build credit. You can apply, get approved, and receive money in minutes through your smartphone. Because the loan is repaid in multiple installments over time, Possible reports to all three credit bureaus as loan principal and interest payments are paid. Compared to credit builder loans, a loan with Possible does not require money on hand to build credit. In fact, you can build credit and receive money at the same time.
Credit repair agencies. These companies typically review your credit report, address negative items, and negotiate with creditors about removing items on your credit report. The credit bureaus have 30 days to investigate and respond to your dispute. The total time it takes to repair your credit will vary depending on your disputes and your credit report. The costs of using a repair agencies can range from $35 for one deletion up to $750 or more. Some agencies will charge by the month instead. According to the Federal Trade Commission (FTC), credit repair scams are common so please verify your credit repair agency and steer away from scammers.
Credit repair counseling. Find a reputable credit repair counseling agency to help turn your financial situation around and build credit. One nonprofit debt counseling agency is the American Consumer Credit Counseling (ACCC) but there are many others out there. Costs of credit counseling should not exceed $50 and most legitimate credit repair counseling agencies should charge you little or nothing. Certain states have specific laws about credit counseling and managing debt.
Authorized user or co-signer. A parent or friend can make you an authorized user on a rewards credit card, allowing you to build credit by relying on the credit score of another individual. Paying the credit card will affect the credit history of those involved. Some credit cards charge fees for adding an authorized user. Adding a co-signer to your credit card, unsecured personal loan, or car can allow you to qualify for loans and products that you would otherwise not qualify for with your low credit. Both signers are obligated to repay the loan.
Benefits of Credit Builder Loans
- Pushes you to save money consistently. With a credit builder loan, you are essentially “depositing” money at regular intervals and at the end of the loan term, the funds are then returned to you.
- Approval is easier than other loan products like personal loans, student loans, other traditional loans or credit cards. Because a credit builder loan is secured by the cash in the bank account (secured loan), approval rates are significantly higher than other credit products.
- As you make payments on time, you will build payment history, an important part of credit history. The bank or financial institution will report payments to the credit bureaus, allowing you to build credit and hopefully improve your credit score.
- Interest is low compared to some other products. Not only does the APR tend to be lower than some other loans, you may receive a dividend or refund on a portion of the interest you paid.
Risks of Credit Builder Loans
- Credit builder loans are not free. You will pay interest on the loan and some financial institutions, such as Self Lender, charge a non-refundable administrative fee. You should read all the agreements and documentation related to your credit builder loan before borrowing the money.
- Late and missed payments can be reported to the credit bureaus which will hurt your credit score. Since one of the primary purposes of the credit builder loan is to build credit history and payment history, this can be frustrating. Keep track of when your payments are due to make sure they are paid on time.
- You are committing to a specific schedule and many financial institutions don’t have the flexibility of rescheduling payments. Properly budget the payments on your loan into your monthly budget so you save enough to successfully pay your credit builder loan. If you need payment flexibility, you can try a Possible loan which allows you to change the payment dates directly within their app with no fees.
Laws and Regulations for Credit Builder Loans
Credit builder loans are usually a combination of two products: a loan plus a savings account/CD.
A personal loan or a line of credit are common loans used for a credit builder loan. These loans have federal laws that govern it, such as the Fair Debt Collection Practices Act and the Truth in Lending Act. The Fair Debt Collection Practices Act by the Federal Trade Commission (FTC) governs debt collection practices and prohibits debt collection companies from using abusive, unfair or deceptive practices when collecting debts. The Truth in Lending Act by the Office of the Comptroller of the Currency (OCC) protects consumers from inaccurate and unfair lending and credit practices. Important aspects of this law include disclosure of the annual percentage rate (APR), terms of the loan, and total costs for borrowers. In addition to these federal laws, there are state usury laws that govern the amount of interest that can be charged on a loan.
A savings account and a certificate of deposit (CD) has a different set of laws that govern it. Federal Reserve Board Regulation D is a federal regulation that sets out reserve requirements for banks in the US. In the US, both savings accounts and CDs may be insured by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Administration (NCUA) for credit unions.
What if I can’t pay my credit builder loan?
Because all payments are reported, not just on-time payments, not paying a credit builder loan can hurt your credit score. With some financial institutions, there is a grace period beginning with the payment due date. For example, Self Lender has a 15 day grace period before they charge a late fee equivalent to 5% of your scheduled monthly payment.
Payments are reported late to the credit bureaus if you are past due by 30 days. In addition, the lender will likely recoup the amount it lent you plus penalties and fees by seizing funds from your savings account for the credit builder loan. This will cause negative entries in your credit report. If you expect to have trouble making any of your payments, work with your lender directly to figure out the best solution for you.
Credit builder loans can be a great way to build credit and save money with little to no credit history. Approval is easy, it’ll push you to save money, and you should improve your credit score as long as you pay on-time. However, plan ahead and don’t miss a payment because failing to pay your credit builder loan will really undermine your efforts.
These loans are not for everyone. If you’re looking to correct negative entries in your credit history, a credit counseling agency or a credit repair agency can help you do that. If you need to build credit and you’re lacking cash, a Possible loan can be a better solution to solve your immediate cash needs while building long-term credit history.