Posted by: Adam McCann

A credit-builder loan is a loan whose only purpose is to help you increase your credit score. Credit-builder loans function the complete opposite way of a regular loan – you pay money to the lender in installments (which go into a savings account), and then you receive the money at the end. During the process, the lender reports your payments to the credit bureaus to help you build credit. Think of it is as a series of savings deposits that help improve your credit standing. However, you’ll owe the lender interest, and may need to pay a fee to open an account.

In contrast, a regular loan gives you a lump sum of money upfront, and then you pay that money back over a specified period of time. Unlike most personal loans, credit-builder loans are open to people who have no credit or even bad credit. This is because the lender doesn’t have much risk since they hold the savings account until you finish paying.

Below, you’ll find a more in-depth explanation of how credit-builder loans work and how they compare to top credit-building alternatives.

Where to Get a Credit-Builder Loan

In order to get a credit-builder loan, you will first need to find a lender that offers them. There are three main places you can look: banks, credit unions and online lenders.

Banks: You’ll typically only find credit-builder loans at local community banks. They tend to have a more personal connection with their customers, similar to credit unions. You can search for banks in your area on WalletHub.

Credit unions: To get a credit-builder loan from a credit union, you will need to become a member. Doing so is usually both easy and free. The only catch is that you have to meet the qualifications to join. That usually includes living, working, going to school or worshipping in a certain area. Other ways to join a credit union include working for certain companies, being a relative of a member or joining certain organizations.

Online lenders: You may be able to find some online lenders that offer credit-builder loans. But be sure to verify they are reputable. Reading reviews from independent sources can go a long way.

Notable lenders that offer credit-builder loans:

• 1st Financial Credit Union: Loans of $300 - $1,000 for 12 months. 12% APR but 50% of interest refunded.
• Sunrise Banks: Loans of either $500 for 12 months at a 21% APR or $750 for 18 months at a 15% APR.
• Self Financial, Inc.: Loans starting at $25 per month for 12 to 24 months. APRs of around 12% - 15%.
• Digital Federal Credit Union: Loans of $500 - $3,000 for 12 to 24 months. APRs as low as 5%.

No matter where you decide to get your credit-builder loan from, the lender ideally should report payments to all three major credit bureaus: Experian, Equifax and TransUnion. At the very least, they need to report to one of those three.

How Does a Credit-Builder Loan Work?

A credit-builder loan works the opposite way of a regular personal loan, but the start of the process is similar to how you’d go about getting a personal loan. First, you’ll need to compare lenders. When deciding which lender is best for you, it’s important to look at the loan amounts they offer, their APR range, their fees and whether the savings account is interest-bearing.

Next, you’ll submit an application. This process is very similar to applying for a normal personal loan. The application will include such things as your address, income, employment status and housing status. You may also need to provide proof of income, employment, existing bank accounts and more.

Before opening your credit-builder loan account, you may have to pay a small, one-time administration fee. Some lenders may also charge a fee for late payments.

A credit-builder loan really starts working differently from a personal loan after the borrower’s application is approved.

• The lender opens a savings account: After the lender approves your application, they set aside the amount of the loan in a savings account for you. But you will not have access to this account until you pay off the full loan amount plus interest.
• You make payments: You will make equal monthly installment payments to the lender over six to 24 months, depending on the size of the loan and the lender’s policies. Most credit-builder loans run from $300 to $1,000, according to Experian.
• The lender reports your payments to the credit bureaus: The lender will report your payment status, whether on-time or late, to the credit bureaus each month. If you are responsible and pay on time, your score should increase. If not, your score will decrease, defeating the purpose of the loan.
• The lender charges interest: APRs tend to range between 6% and 16%. However, the cost of this APR may be slightly reduced by interest you earn on the savings account, if the lender puts your money in an interest-bearing account. In addition, the lender may return some of the interest you pay on the loan at the end.
• You receive the funds: Once you have finished making all your payments on the loan, the lender will give you access to the savings account or wire the money to an account of your choosing. You will be free to use the funds for whatever you wish.

If you take out a credit-builder loan, it’s best to pay only what’s required of you every month. The whole point of a credit-builder loan is to have monthly payments reported to the credit bureaus. Paying it off early would mean fewer months of positive payment history.

You should also try your best to avoid late payments. Having a payment reported as late to the credit bureaus will hurt your credit-building efforts.

Credit-Builder Loan Alternatives

A credit-builder loan is a way for people with bad credit or no credit to improve their credit standing. However, credit-builder loans are not the only way for people in this situation to build credit. Other options include getting credit cards, being an authorized user or taking out a traditional personal loan.

Credit cards: People with bad credit or no credit have a high chance of qualifying for a secured credit card if they can put down the minimum security deposit (usually $200 - $300). But there are also unsecured cards (including student cards) that don’t require a credit history.

Credit cards are the best way to build credit because they report to the credit bureaus monthly whether or not you make any purchases. Making a small purchase and paying in full by the due date will build your score most quickly. But the most important part of building credit with a credit card is to make on-time payments.

Authorized user: If can’t get your own credit card account or don’t want to, you can become an authorized user on someone else’s account. As an authorized user, you can make purchases using the primary user’s credit line if they allow you to do so. But only the primary cardholder is responsible for paying. If the primary cardholder pays on time and the two of you keep a low credit utilization ratio, both of your credit scores will improve.

Personal loan: Some lenders will offer personal loans to people with bad credit. But they will likely charge high interest rates – as high as 36% in some cases. Federal credit unions cap their rates at 18%, however, and some may accept applicants with bad credit.

Another alternative is a secured personal loan, where you must put up collateral to take out the loan. But if you default, you could lose your collateral to the lender. Both secured and unsecured personal loans report payments on a monthly basis to the credit bureaus.

Bottom Line

Credit-builder loans can be a good option for people who have a few hundred dollars they’re willing to temporarily part with in order to build their credit. Though you won’t get all of your money back, considering that you’ll have to pay interest, the improvement in your credit is worth more. It will help you on your way to getting financial products with better terms in the future. And the better your credit score is, the easier other aspects of life may become as well, like getting an apartment or a job.

However, before you take out a credit-builder loan, be sure to consider your other options first. Depending on your situation, a credit card or a personal loan may be more helpful.

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via Finance Xpress