There are a lot of different types of loans and lenders out there. Knowing how they work is the first step to making wise financial decisions. But is there really a loan out there that can help me build my credit? Let’s get right down to it: what is a credit-builder loan?
A credit-builder loan — This is less of a traditional loan and more of a process of saving money and improving your credit. The lender will put a specified amount of money into an account, and then you make fixed monthly payments until you reach that amount. Once you pay the full amount, it’s returned to you, making this more like a savings account than an actual loan.
Credit-builder loans are a good way to save money while also improving your credit score. It can allow you to establish a record of on-time payments without having to take out an actual loan or open a credit card.
What Is Your Credit Score, and How Does It Work?
If you’re curious about a credit-builder loan, then you’re probably trying to find ways to improve your credit score. But what exactly is a credit score, how does it work, and what does it mean for your financial life? These are all great questions that need to be answered if you want to be financially independent.
A credit score is a three-digit number representing your financial trustworthiness. Several companies track your financial behavior and assign you a number based on how well you manage your money. This means lenders look at your credit score to determine whether or not to work with you.
How Will Your Credit Score Affect You?
A good credit score means better interest rates and more favorable terms and conditions. A poor credit score means you may have trouble being approved for loans. And if you are approved, you likely won’t receive excellent interest rates or terms.
It may sound backward, but having a low credit score can be pretty expensive. It means high-interest rates, which means you end up paying a lot more over time for things like loans, credit cards, mortgages, etc. So the best way to improve your financial situation is to start with your credit score.
High-interest rates and unreasonable repayment conditions can make it nearly impossible for low-credit borrowers to get the money they need. But the reason these lenders offer terms like these is because they are taking on more risk than they would be with a good-credit borrower. To make up for this added risk, they increase their rates.
How Do The Credit Bureaus Determine Your Credit Scores?
There are three major credit bureaus: Experian, Equifax, and TransUnion. And you will likely have a credit score with each of them. They all compile your financial information into a document called a “credit report.” This report is what they use to determine your three-digit credit scores.
Your score is determined by a handful of financial behaviors, each with its own weight on the overall score. Here’s what they’re looking for:
- 35% of your score is determined by your payment history
- 30% of your score is based on the total amounts you owe
- 15% of it is based on the length of your credit history
- 10% is based on new credit accounts opened
- 10% is based on your “credit mix” or how varied your open accounts are
As you can see, the most important factor is your payment history. If you have a good history of paying your bills on time, you will likely have a decent credit score with each of the credit bureaus. This is why it’s so important to always pay your bills on time. It can drastically reduce your overall credit score.
This is also why a credit-builder loan can help you improve your score over time. Credit-builder loans are designed to do precisely what their name implies: build your credit.
What Is Good Credit?
The most common credit scoring model is the FICO score. This model scores borrowers on a scale between 300 and 850. Here’s how lenders view borrowers based on where they land on this scale:
300–580: Poor credit
580–669: Fair credit
670–739: Good credit
740–799: Very good credit
800–850: Excellent credit
Keep these scores in mind as you work to improve your credit. Build good financial habits, and you’ll watch your score slowly climb the credit ladder.
How Do Credit-Builder Loans Work?
Your specific credit-builder loan will depend on the lender that you choose.
So make sure you ask plenty of questions before you sign for one. But in general, they work like this:
- Once you find the credit-builder loan and lender you want, you’ll fill out an application.
- The lender will likely look at your personal and financial information, including banking information, to determine whether you qualify.
- If you are approved, you will find out how much you qualify for. In some cases, amounts may range from a few hundred dollars up to a thousand dollars.
- You will then make payments to the lender over the course of a few months or even a couple of years, depending on the loan in question.
- Once you complete all of your payments, the lender will return all of the money to you. But you’ll need to find out from the lender whether or not the interest will be returned as well.
- At this point, you’ve completed the loan agreement, and now you have a solid bank account with emergency savings and potentially a higher credit score.
Keep in mind that this process will largely depend on your specific credit-builder loan and may differ from lender to lender.
Where Can You Find Credit-Builder Loans?
A credit-builder loan can be found at many of the same places you would find traditional loans.
One place you can find credit-builder loans as well as traditional loans and other financial products would be a credit union. Credit unions are like banks, but they are non-profit organizations that focus more on their members. Because of this, you may be able to get better interest rates at credit unions.
You can also find credit-builder loans through online lenders. This is often many people’s preferred method, as you won’t have to leave home to research lenders, apply, and receive approval.
Some banks may also offer credit-builder loans. You may have more luck with smaller community banks. If you want to go this route, simply call around to find out if any banks in your area offer credit-builder loans.
Other Ways to Improve Your Credit History
A credit-builder loan is not the only way to improve your credit report and credit scores. There are plenty of other ways to build credit or improve the credit score you already have. Here are a few of the most common options that could help you build credit.
Secured Credit Cards
A secured credit card is one way for someone with no credit history to begin to build one. For this credit card, you would be required to put money onto an account, and then you can spend up to that amount using your card.
The amount you put on the card acts as collateral in case you don’t make your payments. A secured credit card is a safer option than a regular credit card for someone looking to build credit.
Unsecured Credit Cards
Traditional unsecured credit cards can also help you build credit. As long as you always make your payments on time, you should begin to see your credit score improve.
The difference between this card and a secured card is that you won’t be required to offer up any collateral. This can be good or bad. It’s good because you can get one without offering any money. But it can be dangerous for some borrowers if their spending gets out of control. Credit card debt can rack up quickly, so be conscious of your spending if you use one.
Personal loans or traditional bank loans can also improve your credit if you make your monthly payments on time. Essentially, any loan or financial product can improve your credit if you pay on time and your payments are reported to the credit bureaus.
Personal loans are usually installment loans that you pay off monthly over several months or even a couple of years in some cases. You can find them through online lenders, some credit unions, or at other storefront locations.
The Bottom Line with Credit-Builder Loans
A credit-builder loan is just one option for practicing good financial habits and building your credit score and savings account. A credit-builder loan might be wise if you don’t have a credit score yet because you’re young or you haven’t had any credit accounts.
As with any type of loan, you’ll want to research lenders to ensure you’re finding the right one for your specific situation. You will likely have to pay interest. But it would be best to find a credit-builder loan that will return your interest as well as the principal once you pay it off. It’s also important to make sure that the lender reports your credit-builder loan payments to the credit bureaus so that they make it onto your report.
Now that you’re familiar with what it is, you can decide if you can make a credit-builder loan work for you. Learn more about loans, the three credit bureaus, Building credit, and credit reports in the rest of the CreditNinja Dojo!