Create, restore credit with a credit-builder loan

These small loans come in a variety of flavors with a range of interest rates


Have bad credit, a thin credit file or no credit? A little-known tool called a credit builder loan may be just what you need.

Credit builder loans are small loans, made by some credit unions and a few banks, designed to help consumers establish or boost a credit profile.

Different types of credit builder loans also offer other financial benefits. For example, an unsecured (meaning no collateral is needed) credit builder loan offers a lump sum upfront that can be used for an emergency expense, such as a car repair, new appliance or medical expense. Another type, which freezes the loan proceeds until the total amount has been paid off, forces you to save.

Create, restore credit with a credit-building loan

About one in five credit unions offer credit-building loans to members, says Mike Schenk, vice president of economics for the Credit Union National Association.

Most credit-building borrowers seeking a loan do so as a step toward a financial milestone, such as getting a credit card or obtaining a mortgage, says Sarah Chenven, director of programs and strategic initiatives for the Credit Builders Alliance, a nonprofit organization that helps improve consumer access to credit.

"People usually have a larger goal in mind," she says.

The basics of credit-builder loans
Credit-builder loans usually are offered in modest amounts, typically ranging from under $500 to $1,500, to consumers who need credit help, but have their financial situation under control.

For example, the Greater Iowa Credit Union requires a borrower to have been a member for at least three months, to have six months at either their current job or residence, and to have no recent checking overdrafts, says Alan Johnson, senior lender at the Greater Iowa Credit Union. "We want to see some stability."

Interest rates vary, but tend to be lower for secured loans and slightly higher for unsecured loans, Johnson says. For example, the Greater Iowa Credit Union offers a two-tier, credit-builder program where the borrower first gets an unsecured loan for $1,000 and repays it over seven months, then can borrow $1,500 over a year. The interest rate is set based on risk, and an APR for a consumer with no credit score could be as high as 19.99 percent, Johnson says.

"You might get sticker shock at the rate," he says, but he adds that rates seem high because the loan amounts are low. In fact, the total amount of interest paid on the first loan at that rate would be $67, he says.

Lenders structure the loans in different ways. However, there are three main types of credit building loans:

  • A loan secured by the loan funds. With a "pure credit-builder loan," the lender puts the loan amount in a locked savings account and gives it to the borrower only after receiving the final payment, Chenven says. "It's very safe for the customer and very safe for the issuer," she says. For example, Republic Bank offers loans of $500, $1,000 or $1,500 for 12, 18 or 24 months. The APR ranges from just over 6.8 percent on $1,500 borrowed for two years up to 23.3 percent on $500 borrowed for one year. There are two upsides: you don't have to come up with cash upfront to secure the loan and you end up with a nest egg.
  • A standard secured loan. This type of loan is secured by money the consumer already has in a savings account or certificate of deposit. For example, Achieve Financial Credit Union in Connecticut offers a secured credit-builder loan at an APR of 12 percent plus the interest rate on the account being used as collateral. The collateral account is frozen, and funds are released incrementally as the loan is paid down. "The challenge is, do you have the money to put down?" Chenven says.
  • An unsecured loan. Unsecured credit-builder loans work well for consumers who need cash upfront for a personal expense, Johnson says. "You get the loan, and you have the money in your pocket that same day," he says. St. Mary's Bank, a New Hampshire credit union, for example, offers an unsecured credit-builder loan for a maximum of $500 for 12 to 24 months at 7.74 percent APR with payments made by automatic funds transfer. If you pay off the loan as agreed, the interest gets refunded. Unsecured credit-builder loans provide an excellent alternative to payday loans, as long as the consumer can get the loan and afford the payments, Chenven says.

How a credit -builder loan affects your credit
So, what happens to your credit after you get a credit builder loan and start making payments? If you're starting out with no credit history at all, you will create one with the loan and can get a credit report once the loan account is reported to the credit bureaus, according to Experian, one of the three major bureaus.

Some people get impatient and want to pay it off sooner, but the whole purpose is to build credit, and credit takes time.

-- Alan Johnson
Greater Iowa Credit Union

After a credit report is created, it takes about six months to get a FICO score, says Ethan Dornhelm, principal scientist for FICO. That's because FICO needs enough information on the credit file to determine accurately a borrower's level of risk, Dornhelm says. Consumers may go from no FICO score to the mid-to-upper 600s, or in some cases up to 700, during the loan period, Chenven says.

If you started out with bad credit, a credit-builder loan should increase your score, Chenven says. One caveat, though: even if you're paying your loan on time, ongoing problems on other accounts, such as late payments or collections, can skew your results. Generally, though, a score might go up about 20 to 25 points over the life of the loan, she says.

Even a small increase in score can help consumers if their credit goes, for example, from poor to fair or fair to good. "If it moves them up into a less risky credit scoring tier, that's great," she says.

Making a credit-builder loan work for you
Considering a credit-building loan? Here are five steps to take to get the most out of the product:

1. Assess your readiness. If you're unemployed or having trouble paying your bills, you should wait to apply for a loan, says Debbie Smith, a credit counselor at ClearPoint Credit Counseling Solutions. You might not get approved and, if you do, you could have trouble paying. "You don't want to make bad matters worse," Smith says.

2. Shop for the right loan. "Credit-builder loans come in many shapes and sizes," Chenven says, noting that some of the organizations that are members of the Credit Builders Alliance offer the loans only to "target markets," such as domestic violence survivors, people with disabilities, refugees or youth. Start by asking your own bank if it offers a credit-building loan, then check local credit unions, Smith recommends.

3. Know the terms. Get specifics on any loan you're considering, including how it works, whether you need to put up collateral, the interest rate, the monthly payment amount and whether payments are reported promptly to all three credit bureaus. "If there's something you don't understand, ask until you do," Smith says.

4. Always pay on time. It's crucial to pay on time because both positive and negative information gets reported to the credit bureaus, Johnson says. So, it's a good idea to set up automatic payments, but you have to make sure the money is in your account. "You don't want to get caught paying overdraft fees," Smith says.

5. Don't rush repayment. Take the full time period to pay off the loan. "Some people get impatient and want to pay it off sooner," says Johnson. "But the whole purpose is to build credit, and credit takes time."

By slowly and successfully repaying the credit-builder loan, you increase your chances of getting other types of loans. "You've kind of established yourself as someone who's able to handle credit," Johnson says.

See related: New to US? A primer on how to create, build a credit history, Want a mortgage? Ditch cash-only, build a credit history

Published: April 23, 2015

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