A small loan to build credit may or may not be a good idea, depending on how you repay the loan and your current financial situation. For example, if you miss or make a late payment on that loan, it will hurt your credit, while on-time payment can help your credit.
In today’s world, good credit can create a lot of great financial opportunities. But when you have bad credit or no credit, how can you fix it? One of the most effective options is to take out a small loan that can build or repair your credit. A personal loan can help people solve short-term money problems and create ways to improve credit reports and credit scores.
If you want to know if getting a small loan to build credit is a good idea, read on—we’ve got some information here that can help!
How Credit Scores Are Created
When people talk about credit—especially when it comes to financing and loans—they usually refer to your credit score. Your credit score is a rating that tells potential lenders and creditors how risky it would be to work with you. Credit scores essentially provide insight into a person’s ability to manage and repay their debt.
Your credit score is a part of your credit report. Credit reports are issued for every consumer. They are created by companies called credit bureaus. The three major credit bureaus are Equifax, Experian, and TransUnion. You have a credit report and credit score if you have ever applied for a loan, a credit card, or even rented a house.
Your credit report is determined by five factors that bear different weight on your score:
Payment History (35%)
Your payment history is the record of all of your on-time and late payments. When banks decide whether or not to grant you a loan, they will look at your payment history to see if you are a good candidate for lending money. A negative mark on your history (i.e., unpaid or delinquent accounts) can affect your score by as much as 100 points. Other things like bankruptcy, foreclosures, and debt settlements can also affect it. The best way to protect your payment history is to pay your bills on time, all the time. And when you can’t make a due date, contact your creditors to arrange a repayment plan that can work. Making arrangements will help avoid your account being reported to the credit bureaus.
Credit Utilization Ratio (30%)
Credit utilization is a measurement of how much of your available credit you’re using. For example, let’s say you have a card that has a limit of $1,000. At the end of a month of spending, the balance on the card is $300. That would make your credit utilization ratio 30%. Keeping your utilization at 30% or below will help you maintain a strong score. Additionally, this habit will keep the majority of your credit available for when you really need it.
Length of Credit History (15%)
Each credit account will show up in a credit history. This will show how you have handled these accounts over time and might predict how you will react in the future.
New Credit (10%)
When you are applying for a credit line or loan, trying to get other lines of credit (like credit cards) can harm a financing decision. Applying for multiple credit accounts can make it seem like you are in some major financial trouble.
Credit Mix (10%)
A variety of accounts can show creditors that you know how to manage different types of credit. For example, your car loan and a credit card would be a good mix because they are two different types of accounts that have varying repayment requirements.
The credit bureaus analyze these five factors and generate a separate report for everyone. They use a scoring system that rates each consumer with a number ranging from 300-850:
- 300-579 Poor
- 580-669 Fair
- 670-739 Good
- 740-849 Very Good
- 800-850 Exceptional
A good portion of Americans—about 20%—are living with bad credit. And according to the Consumer Financial Protection Bureau, about 26 million people are “credit invisible,” a fact that is not as cool as it sounds.1 Credit invisible people don’t have any history of accounts reported to the credit bureaus, which means that they have no credit score at all.
Many people find themselves in situations where they need to build up their scores. Not having credit can be just as restrictive as having bad credit. “When consumers do not have a credit report or have too little information to have a credit score, the impact on their lives can be profound,” said Richard Cordray, former director of the CFPB. “And … this may be limiting opportunities for some of the most economically vulnerable consumers.”
Building credit can be tricky, especially if you have bad credit. However, if you don’t have any credit history, it can be even more challenging. But, there is a way to build credit and raise credit score: a credit builder loan.
What Are Credit Builder Loans?
Credit Builder Loans are designed to help people who have bad credit or limited credit histories get started on the road to having a better score. These loans provide a way for people to create a credit history, which is critical to gaining access to loans and lines of credit. The loans are ideal for people who need bad credit loans, such as payday loans or cash advance loans, and cannot get approved anywhere else due to their bad credit history—or lack of any credit history.
How Does a Credit Builder Loan Work?
When approved for a traditional personal loan, the borrower receives the funds and then pays it back over time. A credit builder loan is designed to reverse that money flow. The borrower is required to repay the loan before they receive the money. Payments are held in a savings account until the loan amount and interest are repaid. Credit builder loans allow you to make payments every month until it is paid off, then the money in the account will be available for withdrawal. Credit builder loans are set up this way to help people establish a record of trustworthy financial behavior.
It’s important to make payments on a credit builder loan regularly. This is because your score depends heavily on your payment history. The activity on a credit-builder personal loan is reported to the three major credit bureaus. That means that the way you repay the debts can have a significant impact. Providing evidence of timely payment for a personal loan will help build up your credit rating over time. This kind of information can help improve your score and get you moving in the right direction.
How To Get a Credit Builder Loan
A credit builder loan is not a product that is widely advertised. You may have heard of them as “fresh start” or “starting over” loans. Smaller financial institutions typically offer these loans at lower interest rates with fixed monthly payments—which is a perfect scenario for someone trying to rebuild credit. These loans can be used to build your score up, which, in turn, helps you get better rates on future loans.
Getting a credit builder loan makes it easy to build credit by borrowing small, affordable sums of money over time. To get a credit builder loan, you will need to do the following:
Find a Lender
Credit builder loans are found at local banks and credit unions. Additionally, some of these types of loans are available online. For any credit builder loan you choose, be sure that the lending institution reports your payment history to the credit bureaus.
Choose Your Loan Amount
According to the CFPB, credit builder loans typically range from $300 to $1,000. Since you have to repay the loan before you get the money, it’s important to pick a loan amount with affordable monthly payments.
Compare a few options before you decide on a credit builder loan. Interest fees, monthly payments, and loan terms can vary among lenders.
When you get approved, you’ll make payments until the loan is repaid in full. Then, the money will be made available to you.
Other Ways To Build Credit
You may discover that a credit builder loan may not be the best option even after considering the advantages. Let’s take a look at a couple of other ways you can build credit:
Get a Secured Credit Card
An unsecured credit card is a credit card that is not backed by collateral. Instead, it is determined by factors such as your credit score, debt & history. On the other hand, a secured card has a limit that you will have to fund. This type of card requires the user to make a cash deposit with the bank issuing the card. The deposit put down to fund the limit is usually $200-$500. With this option, you control the limit.
Secured cards can be a useful tool for those looking to increase their score. Secured cards are not seen as an easy source of credit by lenders and have higher interest rates than unsecured cards, but they can help a person develop a positive history as long as the payments are on time.
Dispute Credit Report Errors
Now that you know about your credit report, you can be on the lookout for errors that may appear on it. Common report errors include:
- Closed or settled accounts listed as open and with balances owed
- On-time payments are incorrectly listed as delinquent
- Incorrect credit limits or balances listed
- Unauthorized credit inquiries and charges
- Incorrect ID information (misspelled names, incorrect addresses, etc.)
One of the best things about managing your credit score is the capability to check your report. It’s not a bad idea to review your information against your financial records to determine any credit-damaging errors. If you find an error, you can file a dispute—a challenge to verify the history. Disputes are resolved within 30 days. Filing a dispute is free for any consumer.
Have Your Monthly Bills Added To Your Credit Report
The bills that you are paying on time may not appear on your credit report. However, some of the bureaus offer options that can connect your bank account to your report so that they can positively impact your score.
Become an Authorized User
You can help your score by being an authorized user on someone else’s credit card. They may not even buy anything with it, but adding you to the account will positively affect how banks see them. If they choose, the primary credit cardholder can allow you to make purchases on the card and even limit how much you can spend.
Since you’re not the primary account holder, your credit will increase by a moderate amount. The only way this would impact your score is if the account remains in good standing. It is best to use this tactic in conjunction with other methods to build credit.
Conclusion With CreditNinja
A credit builder loan can be a great tool to build your credit from scratch or change bad habits that have hurt your credit. But make sure to find them with the best rate possible and carefully consider the terms before you sign any agreement. With any loan, it is imperative that you make payments in full and on time. Having a delinquent account will only hurt your credit score.
The secret to having good credit is keeping your debt manageable. Learning how to live within your means is a lesson that will help build good financial habits. Building credit can be easy. The real challenge is to keep that credit in good standing. To learn more about credit and finances in general, check out CreditNinja’s dojo.