Key Takeaways:
The importance of maintaining a good credit score can’t be underestimated. Not unlike a personal resume, a serviceable credit score can help lenders identify worthy borrowers and make their offerings more or less attractive. The better the credit score, the more likely the borrower will receive better underwriting on a loan. However, it is worth noting that not everyone has the luxury of experiencing the benefits associated with high credit scores.
According to Experian, the average FICO Score in the U.S. rose to 711 in 2020, which is “good,” but leaves room for improvement. What about those who have their sights set on “very good” and “excellent” credit scores? What can people do who want to improve their current standing? The answer is simple: take out a loan. In particular, a credit-builder loan can help people improve their credit score.
What Is A Credit-Builder Loan?
A credit-builder loan is exactly what it sounds like: a loan specifically designed to help borrowers strengthen their credit history. On the surface, loans designed to help credit scores look a lot like their traditional loan counterparts. However, it is worth noting that the similarities between traditional loans and credit-builder loans end at their name’s sake.
Traditional institutional loans represent the transfer of capital from one entity (the lender) to another (the borrower). More often than not, the borrowed money is intended to be used for a specific purpose, like buying a house or an automobile. In addition to repaying the entire principal, the borrower is legally obligated to pay interest on the newly incurred debt until the balance is settled.
Credit-builder loans, on the other hand, aren’t initially intended to help people make large purchases. Otherwise known as “Fresh Start Loans” or “Starting Over Loans,” credit-builder loans are designed for the sole purpose of improving someone’s credit history. In fact, borrowers aren’t even granted access to the money they borrow immediately. Instead, the loan is held in a bank account until the loan amount is fully paid. In doing so, borrowers can simultaneously build a savings account and improve their credit score, all while mitigating the risk of falling further into debt.
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How Much Does A Credit-Builder Loan Cost?
Not unlike traditional loans, it pays for borrowers to shop around. Naturally, the competition will enable lenders to charge carrying costs and fees. Whereas some institutions charge a flat fee, however, it’s more common for borrowers to pay down the principal with interest. In today’s market, most of these loans will coincide with an interest rate below 16.0%. They can be expensive at that rate, but the price is often worth the cost of admission when repairing and rebuilding one’s credit report.
How Do You Manage A Credit-Builder Loan?
Credit-builder loans don’t work the same as their traditional counterparts. As a result, borrowers will need to manage their loans accordingly. Most importantly, borrowers should pay special considerations to the following:
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Choose the best credit-builder loan: The easiest way to manage a loan like this is to pick one with manageable payments. If, for nothing else, it is possible to default on loans designed to help credit scores. Therefore, borrowers will want to take on the best credit-builder loan they can manage safely.
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Pay on time: Not unlike traditional credit cards, it’s important to pay credit-builder loans on time each month. Timely payments will go a long way in improving one’s ability to move on to a real credit card eventually.
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Monitor score improvements: Keep an eye on the progress you make while paying down a credit-builder loan. Doing so will set a benchmark and give you goals to aim for.
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Have a plan with the resulting proceeds: It’s not enough to apply for a credit-builder loan; borrowers need to come up with a plan for how they intend to spend the money after the balance is paid in full. That is to say, borrowers shouldn’t spend the money frivolously. Instead, they should apply the money to something more advantageous. Instead of putting the money down on a depreciating car loan, for example, borrowers could keep the money for a rainy day fund or even invest it.
Where Do You Get A Credit-Builder Loan?
Finding a credit-friendly loan is slightly more difficult than finding a traditional loan, if only because they are not typically offered by today’s largest institutional lenders. Credit-builder loan companies are few and far between, compared to larger banks. Due largely, in part, to the risk of taking on borrowers with little or poor credit, larger banks tend to avoid credit-builder loans altogether. Fortunately, credit-builder loans aren’t impossible to find. Prospective borrowers can look for a credit-builder loan at many of the following places:
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Credit Unions
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Community Banks
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Online Lenders
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Lending Circles
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Community Development Financial Institution (CDFI)
Alternatives To Credit-Builder Loans
Credit-builder loans are a great way for people with insufficient credit criteria to improve their standing with credit bureaus. The low-risk nature associated with these loans provides a risk/reward scenario few people can ignore, but they aren’t the only option. Here’s a list of alternative options people may also consider when trying to build and repair credit:
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Apply For A Secured Credit Card: Secured credit cards can serve as a great credit-building alternative to credit-builder loans. Not unlike traditional credit cards, secured credit cards allow their holders to charge purchases to an account. However, unlike a regular credit card, secured cards require upfront deposits (usually somewhere in the neighborhood of $200 to $2,000). The upfront deposit becomes the credit limit and acts as a safety net for those who find themselves unable to pay off the charges. When all is said and done, secured credit cards are the first step to getting a regular credit card, enabling people to build a good credit history.
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Become An Authorized User On Someone Else’s Credit Card: Slightly more unorthodox than the other options on this list, becoming an unauthorized user on someone else’s card (preferably a family member) can be a great first step for repairing one’s credit history. As an unauthorized user, borrowers can use the credit card without being responsible for the payments. Provided payments are made on time, the payment history can benefit the authorized user in the future when they apply for their own card.
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Apply For A Secured Personal Loan: To apply for a secured personal loan, borrowers must put up some collateral. As you would assume, the collateral (something like a car) is used to mitigate risk on the lender’s behalf. If the borrower failed to keep up with monthly obligations, the lender would fall back on the collateral. However, in return, borrowers with poor credit can still receive a loan to build their credit back up. This is a riskier option than applying for a secured credit card, but an option nonetheless.
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Apply For An Unsecured Personal Loan: Unsecured personal loans do not require upfront collateral, but they do have higher interest rates to make up for the added risk. That said, timely payments will help borrowers build a stronger credit history.
Summary
Whether you like it or not, credit is the foundation of many of today’s largest purchases. To buy a house or a car, in fact, most people will need to borrow money. To do so, prospective borrowers will need to prove they will be able to pay back the original loan (plus interest); for the average credit holder, that’s not a huge problem. However, what about those with poor credit or no credit at all? Fortunately, there’s an option for people to build and repair credit: a credit-builder loan. Thanks to credit-builder loans, anyone can improve their creditworthiness and become a viable option in the eyes of today’s lenders.
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