Establishing and maintaining a solid credit history is a crucial component of a healthy financial life. That being said, there is any number of reasons that can lead to an unexpected financial crisis, which can adversely impact your credit. Job loss. Medical bills. Car repairs; sometimes when we’re teetering on the edge of ruined credit, it’s just one missed payment that finally pushes us over. If it’s happened to you, you’re not alone - according to Vantage Score and Trans Union, approximately 30% of all Americans have bad credit (determined to be a score of 601 or lower). For people who find themselves in this position and are trying to rebuild their credit after a rough patch or even just starting out, a credit builder loan is a great option.
The way these instruments work is fairly straightforward. Typically, a financial institution such as a credit union establishes a secured savings account and deposits a small amount of money into it. The applicant (or borrower) then pays the money back with interest, over a predetermined timeframe in monthly installments. At the end of the term, the borrower then receives the total amount as a lump sum plus any interest or dividend.
This type of deferred payment arrangement is unique and helpful because the lender reports the payments to three major credit bureaus, which in turn helps the borrower re-establish or build their credit over time. After a credit report is submitted, it takes about six months to determine accurately a borrower's level of risk, after which the borrower gets a FICO score. Consumers may gain from zero FICO score to the mid-to-upper 600s during the loan period. Generally, a credit score goes up about 20 to 25 points over the life of the loan. On-time, regular payments are the most important components of your credit score because they represent 35% of the FICO score. That’s how you build your credit standing over time.
Credit-builder, or ‘Fresh Start,’ loans typically have a limit of $500 to $1500, because they are designed to be paid back easily and in a reasonable amount of time. Interest rates vary from 7% to 22% depending on the lender. In addition to those individuals who are rebuilding their credit after a setback or are trying to establish new credit, those who are planning a major financial transaction, such as buying a car or obtaining a mortgage may also find that they can benefit from this type of arrangement.
There are different types of credit builder loans as well. A "pure credit-builder loan" is a loan secured by the loan fund itself, where the lender puts the loan amount in a locked savings account while borrower pays by installment the full amount plus the interest. The loan funds are then released to the borrower in a lump sum only after receiving the final payment. The borrower need not come up with upfront money. In a way, it’s just like forced savings.
A standard secured loan is one that is secured by money the borrower already has in a savings account or Certificate of Deposit (CD) account. A CD account is a temporary account under a term (usually 6-36 months) and interest (usually between 2-3.75%) which will compound over the life of the CD. The amount may not be withdrawn before the maturity date but could be released incrementally as the loan is being paid.
An unsecured loan is a loan that is not protected by the loan fund itself or supported by money the borrower already has in a savings or CD account. The loan amount is available on the same day the loan is approved. Payback is through a predetermined term (usually 12-24 months) and a higher APR rate (usually 7.74%). Once the loan is paid off, the interest gets refunded.
Besides credit unions, there are other types of financial institutions that make credit builder loans available. Credit unions typically have membership requirements, whereas community banks generally just require a bank account or debit card as reference. Community Development Financial Institutions (CDFIs) are organizations established to serve economically distressed communities and underserved markets and populations by providing credit, capital and financial services otherwise unavailable from mainstream financial institutions.
Another option is online lenders. These lenders are generally members of the Virginia based umbrella organization Online Lenders Alliance (OLA) representing the growing industry of companies offering loans online to promote a diverse and responsible marketplace for innovative online financial services. OLA members offer loans with payments starting at $25 a month for a two-year term at interest rates below 16%, and payments are reported to the three major credit bureaus.
Still another unique program is the Lending Circles Program, which is run by the San Francisco-based non-profit organization Mission Asset Fund (MAF). This program offers financial stability to low-income families by facilitating zero-interest lending and credit building. After completing an online financial training course, six to ten participants participate in a program and agree on an amount to save. Each week a different member receives the total weekly contributions until each member has collected exactly what they have contributed. Meanwhile, MAF reports each member's participation to credit bureaus to help them establish or improve their credit scores.
There are ways to make credit-builder loans work for you. Some important factors to consider in order to maximize the benefit of a credit-builder loan are the following:
Assess your financial status
If your financial situation and career are both stable enough to assume on-time regular payments for the duration of the loan, then it’s a good time to proceed. If you're unemployed and having difficulty paying your bills, you should wait before applying for a loan. It’s also wise to have a backup plan for unexpected events like illness or job loss.
Choose the right loan
Establish whether a credit union, community bank, CDFI or a Circle Lending program would be the best for you under the circumstances.
Be aware of the terms and interest rates
Do your research and understand the specific terms and conditions of the loan you're considering. Do you need to put up collateral? At what the interest rate? How much monthly payment is required? Are payments reported promptly to all three credit bureaus? Ask until you are fully clarified.
Always pay on time
Most importantly - always pay on time. This activity, whether negative or positive, gets reported to the credit bureaus, so it may be a good idea to set up automatic payments if you can ensure that appropriate funds are available in your account when payment is due. Any report of overdraft fees would have a seriously adverse effect on you and your credit.
Abide by the full repayment schedule
Building or rebuilding credit takes time. Do not get impatient and rush your payment timeline.
By their very nature, credit builder loans are not meant to be difficult to obtain, and generally speaking, lenders do not look for perfect borrower profiles. At a minimum, though, they look for stability. Borrowers may need to have a steady job held for a certain length of time, or have a checking account with no overdraft reports, check fraud record or unpaid fees. If you’ve found yourself in a rough patch in regards to your credit, or perhaps just starting out and looking to establish new creditworthiness, then these types of loans can provide a great boost to get back on track to establishing solid credit.