7 Ways to Safely Use a Credit Builder Loan

A good credit score can help you to buy a new car or achieve your dream of homeownership. It can even help you qualify for a credit card with an advantageous interest rate and killer rewards. One way to get to a good credit score if you don’t already have one is by taking out a credit builder loan.

At Addition Financial, we offer credit builder loans to our members to help them rebuild or establish their credit history. Credit builder loans have some distinct benefits but if you decide to take out a loan to build your credit, it’s important to know how to do so safely. In this post, you’ll learn the basics of credit builder loans and get our seven best tips to use them safely to improve your credit.

What is a Credit Builder Loan?

A credit builder loan is a type of secured loan that’s designed to help people with no credit history or a problematic history to build their credit and increase their credit score. With a secured loan, a deposit at your credit union or bank in the amount of the loan is used as collateral.

Because the amount of your loan is secured, it’s possible to get a credit builder loan even if you have a low credit score or no credit history. There’s no risk to the lender because your deposit is there for them to take in the event you are unable to make your payments. The Consumer Financial Protection Bureau released a report in 2020 that concluded that:

  • Taking out a credit builder loan increased the chances of borrowers having a credit score by 24%. 
  • People who had no existing debt saw an average increase to their credit score of 60 points after taking out a credit builder loan.
  • People who got credit builder loans saw their savings increase by an average of $253.

In other words, credit builder loans are an easy way to get a credit score if you don’t have one, increase your credit score if you don’t have existing debt and save money at the same time.

How Does a Credit Builder Loan Work?

As we mentioned above, credit builder loans are secured loans. When you get one, the lender deposits the amount of the loan into a savings account in your name. Most credit builder loans are for amounts between $300 and $1,000. 

For the period of your loan, you cannot touch the money that secures the loan. When the loan has been fully repaid, the lender will release the balance to you. For this reason, credit builder loans can be an effective saving strategy as well as a credit-building tool because your deposit may earn interest.

The terms for most credit builder loans are between six months and 24 months. You’ll make equal monthly payments for the term of your loan. The lender will report your payments to the three major credit bureaus, which are Experian, Equifax and TransUnion. The payments help you to establish a good payment history. We should note that timely payments are the single biggest factor in determining your FICO score.

You should also know that some lenders return your interest payments to you at the end of the loan term. You should read the loan terms thoroughly and ask questions to determine whether you’ll receive your interest at the end of the loan.

Now, let’s look at seven tips to help you use a credit builder loan safely.

#1: Choose a Reputable Lender

The first step to protect yourself is to borrow from a reputable lender. Credit builder loans are far less risky than short-term loans such as payday loans and car title loans, but you still need to be confident that you can trust the lender you choose.

Many credit unions and banks offer credit builder loans to their members and clients. If you are an Addition Financial member, you can easily get a credit builder loan with us at affordable rates. We’ll make sure you understand how the loan works and do everything we can to help you build (or rebuild) your credit score.

If you’re looking for a lender, we suggest checking the Better Business Bureau and reading online reviews prior to taking out a credit builder loan. It’s particularly helpful if you can find reviews from others who took out credit builder loans to get an idea of what their experience was.

#2: Understand the Loan Terms

The next precaution you should take is to read the loan terms and documents completely. Any reputable lender will provide you with a sample contract before you sign your loan documents. Read through them and ask questions about anything you don’t understand.

We should note here that legal terms may be confusing and difficult to grasp. Some contracts are written in such a way that they are deliberately obtuse. You may want to have a lawyer read the contract, but an essential first step is to read and follow up by asking for clarification of anything you don’t understand.

After asking questions, take a step back and evaluate. Do you feel comfortable that you understand what your responsibilities are if you take out the loan? Do you understand the terms? If a lender doesn’t answer your questions thoroughly, look for a better option.

#3: Make Sure You Can Afford the Monthly Payments

As we mentioned above, a credit builder loan is a personal loan secured by a savings account. The lender will deposit the loan amount into a savings account, and the amount of the loan will be frozen and inaccessible to you for the duration of the loan.

Your lender will disclose the monthly payment amount to you at the time you take out the loan. While you might be tempted to take out a larger loan thinking that it will be better for your credit score, it won’t help you if you are late with payments. Take a close look at your finances to ensure that there’s room in your monthly budget for the loan payment.

#4: Make All Payments on Time

Credit builder loans help people to create a positive credit history by making timely payments. Your payment history accounts for 35% of your FICO score, so making your payments on time is essential if you want to improve your credit score.

One of the best ways to ensure your payments aren’t late is to set up automatic payments with your lender. You should be able to coordinate your payment due date with the days you receive your paycheck to ensure that you have sufficient funds to make your payments on time.

#5: Do Not Pay Extra

Sometimes, people take out credit builder loans and think they should pay extra to pay off the loan before the end of the loan term. We understand the temptation because, on the surface, it might seem that making extra payments would be beneficial. The reverse is actually true.

If you pay off your loan early, it means that you will have fewer on-time payments appearing on your credit history. You’ll be better served by making all payments on or before the due date for the full term of the loan. If you have a 24-month term, by the time you pay off the loan with regular payments, you’ll have two years’ worth of timely payments to contribute to your good credit history.

#6: Do Not Pay Late

Paying late with a credit builder loan will hurt you because all delinquencies will appear on your credit bureau reports. Even a delinquency of a few days can have a negative impact on your credit score, so it’s important to pay by your payment due date each month.

Be realistic about your ability to make your monthly loan payments. That means reviewing your household budget and determining how much you can afford to borrow. Keep in mind that you don’t need to borrow a large amount to reap the benefits of a credit building loan. Making small payments on time will help you just as much as making large ones.

#7: Take Out Multiple Small Loans

Because your payment history has a significant impact on your credit score, you may want to consider taking out multiple small credit builder loans instead of one large one. With multiple loans, you’ll have more monthly payments that can help you to build your credit history and improve your FICO score.

Another alternative would be to take out both a credit builder loan and apply for a secured credit card. The credit limit of a secured credit card is secured by a deposit that you make at the financial institution issuing the card. Having multiple small monthly payments on your credit history can do a lot to show potential lenders that you can manage your money responsibly. 

Credit builder loans offer people with no credit score or a low credit score to build their credit by making monthly payments on a loan that’s secured with a deposit. Because the lending requirements are minimal, most people can qualify for a credit builder loan. The seven tips we’ve included here will ensure that you use your credit builder loan safely and get the results you want.

At Addition Financial, we have multiple secured loan options, including the Opportunity Credit Building Loan. Click here to learn more and apply for a credit builder loan of your own!

The content provided here is not legal, tax, accounting, financial or investment advice. Please consult with legal, tax, accounting, financial or investment professionals based on your specific needs or questions you may have. We do not make any guarantees as to accuracy or completeness of this information, do not support any third-party companies, products, or services described here, and take no liability or legal obligations for your use of this information.