What is a credit builder loan? Does it work?
Credit builder loans help jumpstart your credit journey
A credit builder loan can help you begin building up your credit
When you apply for a loan or any other credit product, the potential lender typically reviews your credit report and credit score. This is because they need to be sure of your financial standing before approving your application.
If your credit score is low, you probably won’t be approved. This is because a low credit score indicates that your creditworthiness is low, meaning that lending to you is a high risk.
However, there’s a loan that doesn’t require you to have good credit and can even help you build your credit.
Enter: credit builder loans.
What exactly is a credit builder loan?
A credit builder loan is ideal for those who are new to the credit scene. It’s a loan which involves the amount that you’re borrowing being held in a secured savings account or certificate of deposit while you make payments to repay the loan.
This means the funds you borrow are actually inaccessible to you until you have completely repaid the loan. This way:
- Since you can’t access the loan, the risk of lending you money is tempered for the lender.
- The loan assesses your ability to keep up with the required payments as a matter of course.
- It makes it easy for you to save and build your credit at the same time.
Credit builder loans are different from regular loans in that, instead of receiving the money you borrowed first and then paying it off later, you pay off the loan and then you have access to it. As odd as it seems, recall that the purpose of credit builder loans is to establish your ability to make timely payments, not necessarily to have immediate access to cash.
This type of loan, often referred to as a fresh start loan, is usually available through smaller financial institutions like credit unions, community banks, community development financial institutions, lending circles, and even online lenders.
With a basic understanding of what a credit builder loan is, it’s only natural to wonder if it lives up to its name.
Do credit builder loans work?
It works, but you have to do the work.
This means that while the loan is still inaccessible, you have to fully pay it off. As you make your timely payments, the relevant institution will report your activities to the major credit reporting agencies. This will help build your credit as you draw ever closer to the borrowed sum.
However, if you fail to make timely payments, you’re proving that you’re not creditworthy. Your lack of progress will still be reported to the various credit reporting agencies. The result: poor credit health.
Managed properly, credit builder loans are very effective when it comes to boosting your credit health—the CFPB released an analysis in 2020 that proved that people who took out credit builder loans recorded a remarkable increase in their credit scores. This strategy works best for those who have just turned 18 or those who’ve just relocated to the U.S. If this is you, go ahead and apply for a credit builder loan. Just make sure you have your income on lock so you can make the necessary payments.