People who have struggled with credit card debt may have a difficult time rebuilding their credit, so they can qualify for a car loan or mortgage. If you’re looking for a way to improve your credit score, then one option to consider is a credit builder loan.
Credit builder loans differ from traditional loans in some important ways. We put our heads together with one of our outside financial and credit experts to put together this list of pros and cons to help you decide whether a credit builder loan is right for you.
How Does a Credit Builder Loan Work?
A credit builder loan is a type of secured loan that’s backed by money that the borrower deposits into a savings account. If you take out a credit builder loan, you won’t receive any money at the start of the loan term. Instead, it is deposited into a savings account where it secures your loan and earns interest at the same time.
You make monthly payments against your loan and the lender reports your payments to the three major credit bureaus: TransUnion, Experian and Equifax. The on-time payments help to improve your credit score. If you don’t have a credit history because you’re young and just starting out, the credit builder loan payments will help you to establish one.
In most cases, the loan term for credit builder loans is between six months and 24 months. At the end of the loan term, your loan will be paid and you’ll get the money that you secured the loan with plus interest. It may be helpful to think of a credit builder loan as a combination of credit building and savings.
Can You Get a Credit Builder Loan with Bad Credit?
One of the most useful features of a credit builder loan is that you don’t need to have good credit to qualify. Because the loan amount is secured and kept in a savings account, there’s no risk to the lender.
In other words, you can qualify for a credit builder loan if you have the money to put in a savings account per your lender’s requirements. You won’t be denied because you’re not really taking money. You’re simply establishing a good payment history.
You should know that there is still an application process that you’ll need to go through. While a low credit score isn’t a barrier, your lender will still look at your banking history using ChexSystems. If you have a history of bounced checks or insufficient income to cover your loan payments, you may not qualify for a credit builder loan.
Pros and Cons of Credit Builder Loans
Our Addition Financial experts got together with David Clark, a lawyer and partner at The Clark Law Office, and Imani Francies, a Finance Expert at USInsuranceAgents.com, to create a list of pros and cons of credit builder loans. Let’s start with the pros:
- The qualification requirements for credit builder loans are less stringent than for traditional personal loans, making it easy to qualify.
- If you make timely payments, you can build your credit and improve your score. Your payment history accounts for 35% of your FICO score.
- People without existing debt who take out a credit builder loan can expect to see a 60-point increase in their FICO score after the loan is paid off.
- At the end of the loan term, you’ll have access to the savings account and can withdraw the funds you deposited to secure the loan.
- Taking out a credit builder loan can make it easier for you to buy a car, qualify for a mortgage or get a credit card with an advantageous interest rate.
As you might expect, there are a few potential cons to consider as well. Here they are:
- If you have a history of bounced checks, you might not be able to qualify for a credit builder loan.
- Late payments can lead to interest charges that make your loan more expensive than it needs to be.
- In addition to interest, late payments may also have a negative impact on your credit score.
- If you have existing debt, a credit builder loan is not your best option. In fact, the same study that found that people without debt experienced an increase in their FICO score found that those with existing debt experienced a three-point decrease in their credit score.
In terms of who should apply for a credit builder loan, here’s our take. For people who haven’t started building credit or who have recently paid off debt and need help improving their credit score, credit builder loans provide a way to get their financial house in order and lay the groundwork for a financially secure future.
Frequently Asked Questions About Credit Builder Loans
If the topic of credit builder loans is new to you, you may have questions beyond what we have already discussed. Here are some of the questions we hear most frequently and the answers to them.
How Much Can You Borrow with a Credit Builder Loan?
Credit builder loans are typically for low amounts because they are backed by your deposit. For that reason, they are usually for small amounts under $1,000. The small amounts help to keep your monthly payment affordable. They also allow lenders to offer short terms, so you can pay the loan off quickly and access your savings.
Can You Pay Off a Credit Builder Loan Early?
You can pay off a credit builder loan early, but doing so is not an advantage the way it would be with a traditional loan. The purpose of a credit builder loan is to create a positive payment history. For that reason, it’s preferable to simply make on-time payments for the duration of the loan term instead of paying early.
Where is Your Deposit Held While You Repay Your Credit Builder Loan?
The deposit for your credit builder loan is typically held by the lender in a savings account or less often, in a CD. The benefit is that your deposit will earn interest over the term of your loan, helping you to grow your savings while you improve your credit score. At the end of the loan term, you will be able to access your deposit plus any interest accrued during the loan term.
Do Lenders Charge Interest on Credit Builder Loans?
You already know that lenders charge interest on traditional loans. The same is true for credit builder loans. The interest rate will depend on your credit history and the lender’s underwriting standards.
Can I Take Out Two Credit Builder Loans at the Same Time?
People who are building their credit history from scratch, meaning that they do not have a meaningful history or have never had a credit card or loan, may have what’s referred to as a “thin” history. If you don’t have a long credit history, then you might need more than one installment account. If you have the money for the deposits and sufficient income to make multiple monthly payments, you may want to consider taking out two credit builder loans at the same time.
How Can I Know if I Can Afford a Credit Builder Loan?
Before you take out a credit builder loan, it’s important to be sure that you can afford the monthly payments. The good news is that because the loan amounts are small, the payments are affordable for most people. Addition Financial’s Opportunity Credit Building Loans offer a $500 loan with competitive interest rates. In most cases, the payments for a credit builder loan will be between $30 and $50 per month.
Do I Need a Cosigner for a Credit Builder Loan?
Sometimes, people with limited credit history or a low credit score can get a loan only if a friend or family member agrees to cosign the loan. Cosigning means that the person signing agrees to take responsibility for payments if the borrower cannot or does not make the payments. With a credit builder loan, no cosigner is required because the deposit you make acts as collateral and virtually eliminates the risk for the lender.
Is There a Minimum Credit Score to Get a Credit Builder Loan?
One barrier to getting a traditional personal loan can be a low credit score. To qualify for a loan without collateral, most lenders require a minimum credit score of 600. Having a higher score will help you qualify for a more advantageous interest rate. With a credit builder loan, there is no minimum credit score requirement.
Will I Get a Cash Advance with a Credit Builder Loan?
There is no cash advance with a credit builder loan. The money you put up as collateral will be held in a savings account for you and it will be returned to you when the loan is paid in full. If you need immediate cash, a credit builder loan is not the right solution for you.
Credit builder loans can be a good option if you need to build your credit or improve your credit score. The pros and cons we’ve listed here will help you decide whether a credit builder loan is right for you.
Click here to apply for an Addition Financial Opportunity Credit Building Loan.
