To get approved for a loan or credit card, you need a good credit history. However, one common question is how to improve a credit score without first getting approved for a standard loan or credit card. Currently, about three out of ten families lack the credit history required to access much needed financing. So how can this paradox be broken?
Financial institutions have designed several methods people can use to build financial history. One popular and affordable option is to apply for a credit-builder loan. These loans were created to help low-income families improve their financial record. However, there are some details that must be kept in mind. In this article, we explore what are credit-builder loans and how you can use them to get into a better financial situation.
What are credit builder loans
Credit-builder loans were created to help low income families build or repair their financial history. For this purpose, most financial institutions often refer to them as Fresh Start or Starting Over loans. Unlike unsecured personal lines of credit, credit-builder loans do not represent a risk to banks who issue them. As a result, financial institutions can offer these loans to customers without a good credit score. Borrowers only have to show proof they can cover monthly payments.
Credit-builder loans are not meant to finance any expenses. Their sole purpose is to help people improve their credit score by registering loan payments with the three major credit bureaus. As a result, most credit-builder loans get approved for small amounts of money to be repaid in several months.
The main downside of credit-builder loans is that they operate with the same interest rates as unsecured lines of credit. As of 2018, most credit-builder loans offered by credit unions and community banks had interest rates of between 7 and 22 percent. At a maximum of 22 percent, someone paying off a $1,000 credit-builder loan over six months will have to pay $1,110 in total. This means that it would cost them $110 in interest to improve their credit history.
How credit-builder loans work
Credit-builder loans work just like a standard unsecured line of credit. Customers submit an application to a financial institution and after a review process, the request gets approved. However, there is one significant difference. When a traditional loan is requested, the bank gives whatever amount was approved directly to customers. In contrast, when a credit-builder loan is approved, the money is withheld by banks until customers have finished paying.
In general, credit-builder loans are approved for small amounts of money, which ranges from $500 to $1,500. Most credit unions and community banks operate repayment periods of around twelve months and interest rates around 17 percent. However, most perform a study of what local residents can afford to guarantee payments. Additionally, some financial institutions give customers with a history of on-time payments the option to be refunded a portion of total interest paid.
Credit builder-loans are one of the most effective ways to improve credit. However, just like traditional loans, customers are required to commit for a long period of time. Impatient customers might prefer faster alternatives such as a secured credit card.
Where to apply for a credit-builder loan
Credit-builder loans are generally not offered by large financial institutions. Instead, they are offered by credit unions and community banks in order to help nearby residents get their financial history started. Credit unions often ask customers to acquire a membership and reside in the area before gaining access to their loans. Community banks do not ask for membership but they often only serve local residents.
In some places, local credit unions and community banks do not offer credit-builder loans due to low demand. However, customers might still be able to get one through Community Development Financial Institutions, or CDFIs. These organizations are established to help low-income families improve their credit history, and more than a thousand operate across the country. Online lenders and local groups are also a good way to find credit-builder loans, though customers should make sure payments are reported to credit bureaus before signing up.
For some customers, it may seem too complicated finding a local bank that offers credit-builder loans. However, the payoff is generally worth it, as these institutions are able to offer lower interest rates and generous payment terms.
Other ways to build or improve credit
Credit-builder loans have some disadvantages. First, they are hard to find and are approved for low amounts despite maintaining similar interest rates than unsecured loans. Second, they need months of commitment and other complicated requirements. Families who are not interested in a credit union membership or plan to move soon might have a difficult time taking advantage of credit-builder loans.
For them, other credit-building options are more attractive. For example, secured credit cards are offered by several large financial institutions who operate nationwide. They only require a $50-$200 deposit and do not force customers into long payment periods. However, customers must have the money required to make the deposit.
If the objective is to build credit history through loans, getting a co-signer may be a possible solution. Co-signing requires someone with a high credit score who is willing to be responsible for the entire loan if the borrower is unable to pay. Parents and family members can take advantage of co-signing to help younger members get financial history without much risk. A similar solution would be granting relatives authorized used status on an existing credit card.
A significant number of families have seen their credit scores improve in recent years. A healthy economy and available options to build and restore credit are among the causes of this development. However, many still remain in financial hardship, without access to much needed financing. Credit-builder loans are one possible route to overcome these obstacles and improve their financial situation.