How Does a Credit Builder Loan Work?

*Clears Throat* Credit builder loans help build credit.

Well, duh.

But how does it work?

Often called Fresh Start Loans or Starting Over Loans, these clever creations are ideal for those without a credit history or those recovering from a major setback such as bankruptcy.

It’s a simple idea: You open a bank account then take out a small loan – somewhere in the $300-$750 range is typical — from the lending institution that uses the bank account as collateral. Because the loan is secured with collateral, there is no need for a traditional credit check.

Whatever amount you borrow stays parked in your collateral account. You make monthly payments on the loan with income. Payback time can be as little as six months, but usually goes out to 1-2 years. As you pay your loan back, your creditworthiness will improve. If for some reason you default, the money in the collateral account will protect the lender.

When the loan is paid off, the money in the collateral account is yours to keep. The lender will report your successful repayment to the nation’s three large credit-rating bureaus, which will use the information to create or upgrade your credit score.

These loans help solve the old chicken-and-egg scenario of the credit world: You can’t show that you’re reliable until you have a loan, but you can’t get a loan until you show that you’re reliable.

What is a Credit Builder Loan?

Credit builder loans are really not “loans” so much as they are savings accounts that help you build a credit history. They are offered by credit unions, community banks and community development financial institutions (CDFI) to help young people get a credit score or older people repair one.

You take out a small installment loan backed by your savings account. You make monthly payments like you would on any other loan. Once you have paid the “loan” back, the money you paid out is yours and the lender reports your success to the credit agencies.

In the end, you should have demonstrated that you can make payments on time and budget your money. That goes a long way toward gaining (or regaining) the trust of lenders.

How Credit Builder Loans Help

Not certain if a credit builder loan has value?

“Credit builder loans get your foot in the door,” explained Rod Griffin, the Director of Public Education at Experian, one of the three major credit reporting bureaus. “The intent and the purpose is to help someone establish a traditional credit history, so that (consumers) can break the cycle of predatory lending, things like payday loans and title loans, the high interest, high fee, short-term loan marketplace.”

The key element here is that credit builder loans are reported to the credit bureaus. At least, they should be. The credit bureaus use the on-time payments as the basis for establishing a credit score. That is the only reason you would want one.

“Anytime you apply for credit, you should ask and verify that they report their information to the national credit reporting companies,” Griffin advised. “If those payments aren’t reported, it won’t help you build credit.”

What these credit bureaus are looking for is positive payment history. Positive payment information is the most important factor in determining your credit score, so whether you are trying to create a first-time score or are repairing a damaged one, the exercise can enhance your credit history and make it easier to get credit in the future.

Types of Credit Builder Loans

There are two types of credit builder loans: Pure credit builder loans and share secured loans.

Pure Credit Builder Loans

A pure credit builder loan is a tool to build a savings account, while building credit at the same time. The lender puts the entire loan in a savings account where it is frozen until the borrower pays off the entire loan. There is no initial deposit, only monthly payments until you pay off the loan.

Then, the money is yours and can use it as the deposit on a secured credit card. It also goes on your credit report and counts toward a credit score.

This strategy could be useful as a way to build savings for something like a down payment on a car. Adding to your credit history should improve your credit score over time, which could lead to a lower interest rate on a car loan.

Share Secured Loans

The share secured loan uses a savings account as collateral. The borrower deposits a sum of money into a savings account. The lender freezes the money, and as the borrower pays back the loan, equivalent shares of your savings account are unfrozen.

This type of loan could be used by someone to improve credit mix, one of the factors in computing a credit score. It would result in only a modest increase of maybe 10 points, but that might be the difference between a “good” credit rating and a “fair” credit rating, which might be the difference in a percentage point or two on the interest rate you’re charged.

Credit bureaus monitor revolving credit (credit cards) and installment credit (auto loans, mortgages and personal loans like a share secured loan). A share secured loan could help someone who only has credit cards on their credit history, but it may only be a slight uptick since these are typically small short-term loans.

Creditors will be more willing to lend you money now that you have demonstrated you can handle month-to-month payments. They benefit anyone that wants to initiate a credit history or someone with damaged credit that wants to repair their score.

Where to Get a Credit Builder Loan

Credit builder loans are typically offered by credit unions, small banks, online lenders and nonprofit organizations. Each lender has its own requirements and will ask about your income. Lenders often don’t advertise these loans so you will probably to make inquiries. Here are some possible sources:

Credit Unions

According to Steven Rick at Credit Union National Association, approximately 15% of credit unions offer credit building loans. Call your local credit union to see if they offer this type of loan and whether you must be a member to apply. If membership is required, consider moving your checking account to the credit union. Some nonprofit organizations, like credit counseling agencies, offer credit builder loans.

Banks

Community banks are more likely to offer credit builder loans than large commercial institutions. Banks might offer credit builder loans to help you become a borrowing customer in the future. In order to loan you money at a competitive rate, they will want to establish a good credit score.

Online Lenders

Some online lenders offer credit builder loans. Since they usually don’t offer accounts that can serve as collateral, they will instead charge high interest rates for a small loan. For instance, you might have loans payments of $25 a month over two years at 16% interest.

Nonprofit Organizations

Community Development Financial Institutions and some other nonprofits offer credit builder loans to help people in low-income communities establish or improve the credit ratings. Community development nonprofits often charge interest to offset their lending risk but will issue small loans to help borrowers enhance their creditworthiness.

Other Options for Building Credit

A credit builder loan is a valuable tool for establishing or improving a credit score.  They are often a good first step, but other borrowing tools can be even more effective if used conscientiously.

Secured Credit Card

Like many credit builder loans, secured credit cards require collateral to cover potential defaults. Lenders often require a deposit of $200 to $2,000 to open a secured credit card account. The deposit becomes your credit limit and can be taken away if you fail to pay what you borrowed using the card.

Since your goal is gaining access to a traditional credit card, make sure the card issuer reports your repayment history to the three credit bureaus. If you make full payments on time each month, your credit score should improve and eventually allow you to covert to an unsecured account.

Experian’s Griffin said secured credit cards are good for building credit, but have drawbacks for those without any borrowing history.

“Secured credit cards are a very common method for building credit for the first time,” Griffin said. “You can also be added as an authorized (credit card) user, become a joint account holder and have someone cosign for you.

“However, people don’t always qualify for a secured credit card. Perhaps they don’t have a banking relationship initially, or the funds to put in a savings account. A credit builder loan is a tool they could use to start that process.”

Secured Personal Loan

Secured personal loans require you to post collateral that can be taken if you fail to repay the loan according to your agreement with the lender. These can be risky, especially if the collateral is worth more than the loan. For instance, you might offer your car as collateral. If you miss payments, the lender can take you car. If you use a secured credit card instead, the most you can lose is the security deposit.

Secured personal loans use various forms of collateral. Vehicle loans use cars, boats, motorcycles and even private airplanes as collateral. Mortgage loans use real estate, most commonly your house.

Since a secured loan offers the lender valuable collateral, interest rates are often lower than those charged on unsecured credit, like a credit card. They also typically offer longer repayment schedules than unsecured loans. If you want to use the repayment of an unsecured loan to rebuild you credit score, make sure the lender reports your payment history to the credit bureaus.

Secured loans have another advantage: Since the lender has a way to recoup the loan amount if you default, they are usually easier to obtain than unsecured loans.

Unsecured Personal Loans

The difference between secured and unsecured loans is that unsecured loans, like unsecured credit, expose the lender to risk. Lenders typically try to offset the risk of high-risk loans by charging high interest rates and by requiring information about your income, credit scores and other debts. If you are willing to pay more interest, however, they can be beneficial in building your credit, since the credit bureaus will use an history of on-time payments to bolster you score.

Bottom Line

Recent research into credit building loans show that they can be effective in helping credit-challenged people improve their credit scores. However, the research is mixed. Data show that people who already have several lines of unsecured credit are typically not helped by credit-building loans. People with few to no credit lines, however, show significant growth in their credit scores.

The most important thing you can do with any form of borrowing is to make payments on time. Borrowing is useful to cover unexpected expenses or to buy something you need but can’t immediately afford. But debt comes with costs and, depending on your interest rate and repayment terms, it’s usually good to pay off debt expeditiously.

Credit builder loans are no exception. Make sure you make your payment on time, and never fall behind more than 30 days. The point is improving your credit score and the best way to accomplish that is sticking to your payment schedule.

Many lenders give borrowers access to their credit scores on a regular basis. If you have access, you should monitor your credit score yourself. Generally, if you have a low score it should improve along with your payment habits.

If you’re having a hard time managing what you owe, consider contacting a nonprofit credit counselor. Credit counseling can help you create a plan for managing your debt and making payments on time, improving your financial well-being and credit score.

Remember that a credit builder loan isn’t for everyone. It’s usually most valuable for those trying to qualify for credit for the first time or someone hoping to repair a badly damaged credit score. If you already have unsecured credit – think credit cards – and are making payments, a credit building loan probably won’t be useful in raising your score.

As Experian’s Griffin explains, your credit score is derived from a variety of factors and there is no one foolproof method for improving it.

“There is no real silver bullet,” Griffin said. “It’s really common-sense things like always making your payments on time, and on credit cards in particular, keeping that balance as low as possible. If you do those two things, your credit score is going to improve over time, and you’ll get the credit you need. It’s about patience, time and consistency.”