What is a builder loan and how does it work?

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Are you considering using a credit enhancement loan to build credit? Find out how they work, their pros and cons, and alternative options. (Shutterstock)

If you have a minimal or poor credit history, you may find it difficult to qualify for financial products, such as a mortgage or car loan, without a co-signer. And if you’re approved, a lender will likely charge you a higher interest rate than someone with a good credit history.

A credit enhancement loan can be a way to improve your creditworthiness so that you can qualify for better rates and terms in the future. Good credit can make it easier to qualify for products like credit cards and personal loans.

Keep reading to learn more about credit loans, how they work, and other options to consider if you’re working on your credit.

What is a credit builder loan?

A credit enhancement loan is a type of Personal loan designed to help you establish or rebuild your credit. Unlike a standard personal loan, a lender doesn’t pay you a lump sum of money up front, which you then repay with interest over time. Instead, the lender deposits the loan amount into a secure account and releases the funds to you once you have made the payments.

The lender reports your payments to the credit bureaus. So if you have no credit history or a poor credit rating, a credit enhancement loan can help you build your credit — as long as you make payments on time and as agreed. But the impact a credit builder loan will have on your credit score varies.

For example, a 2020 Consumer Financial Protection Bureau study found that study participants who had no existing debt saw their credit score increase 60 points more than participants who had existing debt.

How does a credit builder loan work?

If you are approved for a credit loan, a lender will deposit the loan amount into a locked savings account or certificate of deposit (CD) account. Thereafter, you must make monthly payments over a repayment term that usually lasts six to 24 months. As you repay the loan, the lender reports your payment activity to the credit bureaus.

Although loan terms vary, your loan amount is usually deposited into your savings account in small installments after each payment or at the end of your repayment period, less interest and fees.

Advantages and disadvantages of credit-generating loans

Like all financial products, a builder’s loan has advantages and disadvantages. Before applying, weigh the pros and cons.

Advantages

  • Easier to get than a traditional personal loan — If you have minimal or poor credit, a lender may still approve you.
  • Making payments on time could improve your credit — A lender reports your payment activity to the three major credit bureaus – Equifax, Experian and TransUnion. If you repay your loan as promised, this will add a positive payment history to your credit reports, potentially increasing your credit score.
  • Could help you build your savings — Once you’ve repaid the loan, you’ll get your money back, less interest and fees. Then you can deposit the funds into a savings account or use them as you wish.

The inconvenients

  • Interest and fees — Similar to a traditional personal loan, you have to pay interest (and sometimes fees) when you take out a credit-generating loan.
  • Making a late payment could lower your credit score — If your monthly payment is 30 days past due, a lender can report it to the three major credit bureaus. Therefore, it could lower your credit score, which will prevent you from qualifying for future loans.
  • Could make it harder for you to deal with your current debt — Taking out an additional loan means you have to make additional monthly payments (if you have existing debt). As a result, you may find it more difficult to control the repayment of your current debt.

How much will a credit builder loan cost me?

Your total costs will largely depend on the lender since interest rates, loan amounts offered and repayment terms vary. The higher the amount and interest rate of your loan, the more expensive your loan will be.

Some lenders also charge an upfront administrative fee for processing the loan.

To get a better idea of ​​the cost of a credit-building loan, look at the annual percentage rate (APR) charged by a lender, which is a measure that factors in interest, plus any fees.

How much can I borrow with a credit generator loan?

Credit enhancement loans are designed to help you build a positive credit history, not necessarily to pay for a big expense or purchase. While some personal loans can be in the tens of thousands of dollars, credit building loans are usually for relatively small amounts – a few hundred to a few thousand dollars.

It’s generally a good idea not to borrow more than you actually need. Since the purpose of a credit-building loan is to establish a good payment history, the amount you borrow is not as important as making your payments on time as agreed. A loan of $300 could be as beneficial as a loan of $1,000. But keep in mind that a lower loan amount will mean lower monthly payments.

In fact, depending on your interest rate and the amount you’re borrowing, a credit-building loan could come with monthly payments of less than $100.

Where can I find a credit builder loan?

Several types of lenders offer credit building loans, including:

  • Credit Unions Because credit unions are not-for-profit institutions, they often offer lower interest rates and better terms. But you will need to meet the membership requirements and join the credit union to get a loan from them.
  • Banks – Most major banks do not offer credit-building loans, but some local and community banks may.
  • Community Development Financial Institutions — These financial institutions focus on low-income people who have historically had fewer banking options.
  • Online lenders — Online lenders typically offer digital application and approval processes for credit products. And because they don’t have the expenses associated with physical locations, online lenders often offer competitive rates and terms.

Before applying for a credit loan, remember to research the lender to make sure it is legitimate. This will minimize your chances of falling for a credit scam. And compare loans between multiple lenders to ensure you get the best deal available to you.

Need to build up credit? Alternatives to credit-generating loans

If you want to improve your credit but don’t think a credit-building loan is right for you, consider these alternative options:



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