What is a credit loan and how does it work?

If you want to build credit but your score isn’t strong enough to be approved for a traditional credit card or loan, you may be wondering what your options are. A credit-builder loan could be useful in this situation.

These loan products are aimed at credit newbies or consumers with credit difficulties and offer the best of both worlds – the opportunity to potentially build credit while saving money.

What is a credit builder loan?

A credit-building loan is a financial product with competitive terms that helps you build credit while saving money. It is ideal for people who have bad credit or no credit at all and are having trouble getting credit cards or traditional loan products approved.

Loans are generally available in one hundred dollar increments, from $200 to $2,000, with repayment periods of six to 24 months.

How does a credit builder loan work?

If you are approved for a credit-building loan, the bank will deposit the entire loan amount into an interest-bearing savings account. You will make a fixed monthly payment for a fixed period and receive the loan proceeds (less any applicable fees) at the end of the loan term.

Most lenders charge an administrative fee to open an account. Monthly payments are usually automatically deducted from your bank account to streamline the repayment process and prevent you from missing payments.

The impact on your credit score generally depends on your credit history. A recent study by the Consumer Financial Protection Bureau (CFPB) which consisted of approximately 1,500 consumers found that debt-free participants who opened credit builder loans saw their credit rating increase 60 points more than those with existing debt. Consumers who had existing debt experienced a drop in their credit score.

How to Use a Credit Builder Loan to Your Advantage

Credit builder loans help you build your credit by reporting monthly payments to the three credit bureaus – Experian, TransUnion and Equifax. Payment history accounts for 35% of your FICO score, so timely payments increase the amount of positive activity reported in your credit profile. In turn, your credit score might improve over time.

Plus, you’ll accumulate savings while making payments on your credit loan balance. Once the funds are released, you can store them in a savings account, make a major purchase, or use them however you see fit.

Where to get a credit builder loan

Credit enhancement loans are available from an assortment of lenders, including:

  • credit unions: If you are not yet a member of a credit union, you will usually need to apply for membership before you can apply for a credit builder loan.
  • Community banks: You probably won’t find these loan products at major physical banks, but many local, regional and community banks offer credit-building loans.
  • Lending Circles: They offer credit building plans, which involve interest-free loans that fall under the credit bureaus, for use by groups of relatives or friends. Each member deposits the agreed amount into a central fund each month. Each month, one member of the fund receives money and everyone continues to contribute until all members have received money from the central fund. Consult the association database Mission Asset Fund website to find Lending Circles in your community.
  • Online lenders: Several online lenders, like Self, offer low-cost credit loans that you can apply for and receive a decision in minutes. If you are leaning towards a credit loan, confirm that the lender is licensed to do business in your state before applying.

Most lenders do not require a credit check to qualify for a credit enhancement loan. However, they may review your banking history through ChexSystems, Early Warning Systems, or another consumer reporting agency to determine your eligibility for a loan – unwanted entries, such as NSF checks and excessive overdraft charges, could harm your chances of being approved.

When you are ready to apply, you will usually be asked to provide the following information and documents:

  • Your name, date of birth and social security number
  • Your current address and phone number
  • Your routing and bank account number
  • A copy of your driver’s license, U.S. passport, or state-issued photo ID
  • Your mortgage or monthly rent

Other ways to build credit

A credit building loan is just one way to start your journey to better credit. There are other alternatives to consider, including:

  • Secured credit cards: You will have access to a credit card with a limit based on the required security deposit that you make in advance. A secured credit card can be used like any other credit card, and you’ll need to pay at least the minimum payment each month to keep the account in good standing, as payment activity is reported to credit bureaus each month . Ideally, you want to keep the balance at 30% or less of the credit limit to help boost your score.
  • Personal loans: Some lenders offer unsecured personal loans to those with poor or limited credit history. However, these loans may not be worth it as they will likely come with a high interest rate as they are high risk for the lender. If you can get a secured loan backed by collateral, you may qualify for more favorable terms.
  • Self-declaration: Ask your landlord and service providers to report payment activity to the credit bureaus. They are not obligated to do so, but may grant your request for free or for a nominal monthly fee.

You can also ask a relative or friend with an outstanding credit history to add you to their credit card account as an authorized user. If they agree, you will have the power to make purchases on the account without being obligated to pay. Best of all, you won’t have to submit to a credit check, and any positive payment history on the account will also reflect on your credit report. You can request at any time to be removed from the account as an authorized user.

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