What Is a Credit-Builder Loan (and Should You Get One)?

It’s an age-old dilemma for would-be borrowers: Creditors want evidence you can handle a loan or unsecured credit card before they give you one, but there’s risk in offering credit products to borrowers without a good credit history.

That’s where credit-builder loans come in. These atypical loans, which are mainly offered by community banks and credit unions, give borrowers a chance to show they can make regular payments and ultimately build or rebuild a positive credit history.

If you use a credit-builder loan successfully, it’s likely you can improve your credit history and advance to larger loans over longer time periods and obtain unsecured credit cards.

The Goal of Credit-Builder Loans

Credit-builder loans are designed to make it easy for you to improve or establish a credit history.

The goal of traditional credit-builder loans is to show that you can make regular payments and successfully complete the loan. Unlike a traditional loan where you receive funds at closing, you’ll receive money from a credit-builder loan after you finish paying the lender.

“You don’t have a need for the money; you have a need for a better credit score,” says Michael Emancipator, assistant vice president and regulatory counsel for the Independent Community Bankers of America.

[Read: The Best Bad Credit Loans of 2018.]

How Credit-Builder Loans Work

With a traditional credit-builder loan, the financial institution saves payments in a savings account or certificate of deposit, which may earn interest.

“The customer doesn’t have access to the money but will make amortized payments over 12 months or whatever period is chosen, along with interest,” Emancipator says. “At the end, they can access the money.”

Loans are offered in a variety of amounts, payment periods and interest rates:

— Amounts generally range from about $500 to $1,500 with some loans as high as $5,000.

— Payment periods are usually short, from six months to a year, but may be longer with larger loans.

— Interest rates vary, but some lenders will return a portion of your interest charges.

Banks and credit unions may offer credit-builder loans that are secured by funds in a savings account, as well as ones that are unsecured but allow you to get a small amount of upfront money, likely at a higher interest rate.

“It’s a loan with training wheels — so simple to get, easy to pay back,” says John Ulzheimer, president of The Ulzheimer Group and a national expert on credit who formerly worked with Equifax and FICO. “Unless you’re truly strapped, truly irresponsible, it should work perfectly.”

Who Uses Credit-Builder Loans?

Credit-builder loans are ideal for people who are trying to establish credit — such as recent college graduates, the newly divorced or newly arrived immigrants — as well as those who are trying to rebuild credit after major problems such as bankruptcy.

Once you get something positive on your credit report, it “changes the way lenders and service providers look at you,” Ulzheimer says.

For example, recent college graduates who have yet to obtain credit cards could have a better chance of renting an apartment or getting a mobile phone account thanks to the positive credit history achieved through a credit-builder loan.

“It tends to be a niche product because it works particularly well for people building credit for the first time,” says Jordan van Rijn, Credit Union National Association senior economist.

There are few credit requirements for this type of loan, and the specifics depend on the financial institution. Typically, you’ll need to show that you have a source of income that allows you to make payments of about $50 to $100 each month for the term of the loan.

You will have difficulty getting a loan if you have unresolved financial judgments.

“If that’s the case, we would typically advise people to get those paid off first,” van Rijn says.

Where to Get a Credit-Builder Loan

Community banks, credit unions and online lenders are the most frequent sources of credit-builder loans.

There are more than 5,600 credit unions across the country, and about a quarter of them offer some sort of credit-builder loan, van Rijn says. In total, almost half of credit union members nationwide have access to the loans. Although you must be a member to get a loan at a credit union, it’s fairly simple to become one. Just look for a nearby location and see what the requirements might be, van Rijn says.

[Read: The Best Debt Consolidation Loans of 2018.]

Credit-builder loans are not a great profit generator, which is why some financial institutions don’t offer them. But some banks and credit unions count on these low-risk products to lead customers to more traditional borrowing vehicles such as car loans and mortgages.

Credit-builder loans are not usually marketed heavily to consumers, but it’s worth asking if your bank or credit union offers the loans, and then shop around if needed.

“You won’t necessarily see customers go into a bank asking for this particular product,” Emancipator says. “But it might be brought up by a banker to a customer experiencing financial hardship or who doesn’t have a credit score to go into a more traditional product.”

How Loans Can Build Credit

It can take a while to build a strong credit history, but a successful credit-builder loan is a positive initial step in that process. It could lead to unsecured credit cards and then an installment loan — such as a car loan — within a few years.

It’s not going to have as much influence on the credit score for the customer rebuilding credit as it would for the first-time borrower, but it certainly can help, van Rijn says.

You should establish a credit-builder loan early if you anticipate you might need a credit boost soon. It will take some time for successful loan payments to be reported to the credit bureaus.

“If you know you’re beginning a rough period, go ahead and establish one of these, pay it on time, and you’ll have an anchored date on your credit report that everything from this point forward is positive,” Ulzheimer says.

Before entering into a credit-builder loan agreement, make sure the financial institution will report the loan to all three major credit bureaus. If it only reports to one, for example, the effectiveness of the loan will be greatly reduced.

[Read: The Best Personal Loans of 2018.]

Alternatives for Building Credit

There are ways to build or rebuild credit in addition to or instead of a credit-builder loan:

Secured credit cards: In contrast to more typical unsecured credit cards, secured cards require you to make a deposit before you can use the card, allowing you to spend up to your credit limit, which is often the same as the amount of the deposit. Unlike credit-builder loans, you can get immediate access to funds with a secured credit card. If you make your payments in full every month, you don’t have to pay interest, but interest rates on secured credit cards may be higher than the rate offered by a credit-builder loan, so a secured credit card may not be a good choice if you plan to carry a balance.

Authorized users: With some credit cards, the primary cardholder can add an authorized user to the account. The primary cardholder is still liable for the debt, but the authorized user can benefit from having a credit card account on their credit history. For example, a young person can move from a blank credit report to one that features a 25-year-old American Express card with no balance and perfect pay history, Ulzheimer says. When this strategy is well-managed, it’s a good way to build credit.

Co-signing: If you can’t get a loan, a co-signer with good to excellent credit may be able to help you be approved despite a low credit score or no credit history. But there is a big potential downside for co-signers. “You’re liable for the debt,” Ulzheimer says. “If the other person is not making a payment, it will blow back to your credit report as an obligation being paid late or in default.”

Making a Good Impression

Credit-builder loans can be a good choice for improving your credit history, but there is no guarantee of success. If you get a credit-builder loan, commit to making payments on time and in full every time. You need to show you’re taking credit seriously and can be trusted to take on more important financial vehicles, such as unsecured credit cards and larger loans.

“You don’t want your first account to be a negative account or, worse, a default,” Ulzheimer says. “If you’re trying to rebuild your credit from a negative event and this first loan is not paid on time, you’re not proving to anyone that you can pay on time.”

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What Is a Credit-Builder Loan (and Should You Get One)? originally appeared on usnews.com

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