What is a Credit-Builder Loan and How Do They Work

What is a Credit-Builder Loan and How Do They Work

A credit builder loan is a loan where the amount you borrow is held in a bank account while you make payments, thereby building credit history. Credit builder loans don’t require a good credit score,...

A credit builder loan is a loan where the amount you borrow is held in a bank account while you make payments, thereby building credit history. Credit builder loans don’t require a good credit score, so people with bad credit, poor credit, or no credit history can apply and get approved.

Because the amount you borrow is held in a bank account as collateral, the financial institution or online lender has no risk because it could simply collect the money in the bank account if you were to stop paying. At the end of the loan term, the lender will return the loan proceeds plus any applicable interest.

Because some credit builder loans have no credit check requirements, they can be fairly easy to obtain. Below, we’ll delve into everything you need to know, starting with the basics.

Basics of a credit builder loan

Many lenders do not require a credit check for a credit builder loan. However, even though they may not do a credit inquiry, they may use your banking history or other underwriting criteria to determine whether they will approve you for a credit builder loan. Plus, you may also need to provide the following information to a potential lender:

  • Employment information
  • Paystubs or proof of income
  • Checking account balances
  • Outstanding loan information

According to the Consumer Financial Protection Bureau (CFPB), credit builder loans typically range from $300 to $1,000 in size and are repaid over 6 to 24 months. When choosing a loan amount for your credit builder loan, consider your income and ability to repay the loan. Choose a smaller amount if you’re on a tight budget. Remember, late payments are reported to the credit reporting bureaus, so failing to pay your credit-builder loan undermines your credit-building efforts. On the other hand, establishing a positive payment history will not only increase your FICO score but also open the door for better loan options and access to other financial services.

The amount of interest and/or fees you pay on the loan varies by lender. At the end of the loan, some lenders return the interest together with the amount you borrowed. When choosing lenders, be sure to read all disclaimers regarding interest rates, applicable fees, and lender policies about changing loan payments and returning the interest.

A credit builder loan is not for everyone. If you don’t have the money to spare and have bad credit, borrowing using alternative options like payday loans or a Possible loan could be a better option. With a loan from Possible, you can receive money as well as build credit.

Where to get credit builder loans

Credit builder loans with no credit checks can be a helpful financial tool. For example, MoneyLion‘s Credit Builder Plus program gives you access to a portion of your loan funds immediately without the need for a hard credit inquiry. However, if you’re not interested in paying a monthly membership fee, there are plenty of other ways to get a credit builder loan, including:

Credit Unions: Many credit unions, such as the Massachusetts-based Digital Federal Credit Union (DCU), offer credit builder loans. You can apply online or in person at a local branch. The amount of loan funds credit unions provide usually range between $300 to $1,000, with interest rates averaging 10% and the typical loan term being one year. Repayments are reported to the credit bureaus, and 50% of the interest may be refunded at the end of the loan term.

Banks: Among the many financial products they provide, national, regional and community banks offer credit builder loans as a way to help establish credit or improve a low credit score. For example, Wells Fargo allows for a Wells Fargo certificate of deposit (CD) or savings account to secure a loan or line of credit that you borrow. Payments are reported to Experian, TransUnion, and Equifax.

Self Lender: Based in Austin, Texas, Self Lender works with multiple banks and offers a credit builder account based on a certificate of deposit (CD) backed installment loan. Customers open a CD with a bank through Self Lender and the bank extends a line of credit for the same amount. Payments made are reported to the credit bureaus. Loan amounts, fees, and terms vary and there may be an origination fee.

Lending Circles: Certain community organizations facilitate peer groups that help those within the group build credit. The peer group decides on a monthly payment and loan balance. The loans are usually interest-free with no fees, and each member of the peer group pays the same monthly amount to a central account. Each month, a member of the peer group receives a loan in the agreed-upon loan balance, and payments are reported to all three credit bureaus. You can look up lending circles in your area at Mission Asset Fund.

Process for a credit builder loan

How exactly does the process for obtaining a credit builder loan work? In general, here are the five steps involved:

  1. Lender opens a savings account. Once the lender approves the application, the loan amount is set aside in a savings account for you. So, unlike other loan options that give you the money upfront, you will not have access to the funds until you pay off the entire loan.
  2. You start making payments. You will usually make equal monthly payments for the term of the loan, which can be 6 months up to 24 months depending on the lender.
  3. Payments are reported to the credit bureaus. The lender will report your payments, whether on-time or late, to the three major credit bureaus: Experian, TransUnion, and Equifax each month. If you pay on time, you will build credit history and your FICO score should increase. If not, your score may decrease, undermining the primary reason for taking out a credit builder loan.
  4. Interest is charged throughout. Depending on the lender, annual percentage rates (APRs) range between 6-16%. That figure may be slightly reduced by the interest you earn on the certificate of deposit or savings account. In addition, many lenders will return a portion of the interest back to you when the loan is repaid.
  5. Your loan term ends and the funds are returned to you. Once you have made all the payments on the loan, the lender will give you access to the certificate of deposit or savings account. You will be able to access the money for your own personal use.

The best credit builder loan alternatives

What are your options if you rather not go the credit builder loan route? Luckily, there are several other financial products you can turn to, such as:

Secured credit cards: A secured credit card requires you to place a refundable security deposit on your credit card. The refundable security deposit is the card’s credit limit, which prevents you from spending more than you can repay on the credit card. Secured credit cards offer almost guaranteed approval because the issuer uses the security deposit as collateral if you cannot pay your credit card bills and the outstanding credit card debt. All three credit bureaus receive updates about your payment history.

Possible loan. Possible has installment loans up to $500 that build credit. You can apply, get approved and receive money in minutes through your smartphone. Because the loan is repaid in multiple installments over time, Possible reports to two credit bureaus (Experian and TransUnion) as loan principal and interest payments are paid. Compared to credit builder loans, a loan with Possible does not require money on hand to build credit. In fact, you can build credit and receive money at the same time.

Credit repair agencies. These companies typically review your credit report, address negative items and negotiate with creditors about removing items on your report. The credit bureaus have 30 days to investigate and respond to your dispute. The total time it takes to repair your credit will vary depending on your disputes and your credit report. The costs of using a repair agency can range from $35 for a single deletion up to $750 or more. Some agencies will charge by the month instead. According to the Federal Trade Commission (FTC), credit repair scams are common, so please verify your repair agency and steer away from scammers.

Credit repair counseling. Find a reputable credit repair counseling agency to help turn your financial situation around. One non-profit debt counseling agency is the American Consumer Credit Counseling (ACCC), but there are many others out there. Costs of credit counseling should not exceed $50, and most legitimate credit repair counseling agencies should charge you little or nothing. Certain states have specific laws about credit counseling and managing debt.

Authorized user or co-signer. A friend or family member can make you an authorized user on a rewards credit card, which allows you to build credit by relying on the card holder’s credit score. Paying the balance will affect the credit history of those involved. Keep in mind that credit card issuers like Visa charge fees for adding an authorized user. Adding a co-signer to your credit card, unsecured personal loan or car loan can allow you to be eligible for financial products that you would otherwise not qualify for based on your credit health. Both signers are obligated to repay the loan.

Benefits of Credit Builder Loans

It’s important to do everything possible to keep your credit strong. And if your financial health isn’t where it should be, a credit builder loan can help get things moving in the right direction.

Let’s examine a few benefits of utilizing this tool:

  • A credit builder loan pushes you to save money consistently since you are essentially “depositing” money at regular intervals.
  • Approval is easier than other loan products like personal loans, student loans, other traditional loans or credit cards. Because a credit builder loan is secured by the cash in the bank account (secured loan), approval rates are significantly higher than other credit products.
  • As you make payments on time, you will build payment history, an important part of credit history. The bank or financial institution will report payments to the credit bureaus, allowing you to build credit and hopefully improve your credit score.
  • Interest is low compared to some other products. Not only does the APR tend to be lower than some other loans, but you may receive a dividend or cash back refund on a portion of the interest you paid.

Risks of Credit Builder Loans

While credit builder loans with no credit checks come with several benefits, there are potential drawbacks, including:

  • Credit builder loans are not free. You will pay interest on the loan, and some financial institutions, such as Self Lender, charge a non-refundable administrative fee. You should read all the agreements and documentation related to your credit builder loan before borrowing the money.
  • Late and missed payments can be reported to the credit bureaus, which will negatively impact your credit score. Since one of the primary purposes of the credit builder loan is to establish a track record of responsible payment history, this can be frustrating. Keep track of when your payments are due to make sure they are paid on time.
  • You are committing to a specific schedule and many financial institutions don’t have the flexibility of rescheduling payments. Properly budget the payments on your loan into your monthly budget so you save enough to successfully pay your credit builder loan. If you need payment flexibility, you can try a Possible loan that allows you to change the payment dates directly within the app with no fees.

Laws and Regulations for Credit Builder Loans

Credit builder loans are usually a combination of two products: a loan plus a savings account/CD.

A personal loan or a line of credit are common loans used for a credit builder loan. These loans have federal laws that govern it, such as the Fair Debt Collection Practices Act and the Truth in Lending Act. The Fair Debt Collection Practices Act by the Federal Trade Commission (FTC) governs debt collection practices and prohibits debt collection companies from using abusive, unfair or deceptive practices when collecting debts. The Truth in Lending Act by the Office of the Comptroller of the Currency (OCC) protects consumers from inaccurate and unfair lending and credit practices. Important aspects of this law include disclosure of the APR, terms of the loan, and total costs for borrowers. In addition to these federal laws, there are state usury laws that govern the amount of interest that can be charged on a loan.

A savings account and a certificate of deposit (CD) have a different set of laws that govern them. Federal Reserve Board Regulation D is a federal regulation that sets out reserve requirements for banks in the US. In the US, both savings accounts and CDs may be insured by the Federal Deposit Insurance Corporation (FDIC) for banks and the National Credit Union Administration (NCUA) for credit unions.

What if I can’t pay my credit builder loan?

Payments are reported late to the credit bureaus if you are past due by 30 days. Luckily, some financial institutions have a grace period that begins on the payment due date. For example, Self Lender has a 15-day grace period before it charges a late fee of 5% of your scheduled monthly payment.

In addition, the lender will likely recoup the loan amount plus penalties and fees by seizing funds from your savings account. This will cause negative entries in your credit report. If you expect to have trouble making any of your payments, work with your lender directly to figure out the best solution for you.

Final Take

Credit builder loans can be a great way to build credit and save money with little to no credit history.  Approval is easy, it’ll push you to save money and you should improve your credit score as long as you’re diligent about making payments on time. However, failing to pay your credit builder loan will undermine your efforts to strengthen your financial standing.

These loans are not for everyone. If you’re looking to correct negative entries in your credit history, a credit counseling agency or a credit repair agency can help you do that. If you need to build credit and you’re lacking cash, a Possible loan can be a better solution to solve your immediate cash needs while building long-term credit history.

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