When you have a poor credit history, lenders are reluctant to extend credit to you until you rebuild your credit score. Sometimes that puts you in a catch-22 situation. You need new credit to rebuild your credit score, but no one wants to lend to you.
That's where a credit builder loan can help. This type of loan is designed to help borrowers achieve credit respectability. The best part about a credit builder loan is that you don't need to have good credit to be approved for one.
How a credit builder loan works
Credit builder loans have a safety net for lenders. After you apply and are approved for the loan, the lender puts the borrowed money in a savings account. You can't access the savings account until you have repaid the loan in full. At the end of the loan, your lender will send a good report to the three main credit bureaus that will help your credit score.
According to a 2013 study, the credit scores for people with six months of on-time credit builder loan payments improved an average of 35 points. Some of the loans were as small as $100.
If you don't repay the loan, the lender reclaims the funds in the savings account. In addition, the lender will report missed and late payments to the credit bureaus just like it would for a traditional loan.
Reasons you need good credit
As stated earlier, credit builder loans don't give you access to money. Their sole purpose is to help you improve your credit score. The single biggest factor that affects your score positively or negatively is a history of on-time payments. Late and missed payments are extremely damaging. A credit builder loan will help you demonstrate you can make on-time payments and raise your credit score. But why is having a good credit history and score so important? Let's look at a few reasons.
- Some employers check an applicant's credit history before making a job offer, especially if the job involves handling money or managing clients' money. Companies don't want to put themselves or their clients' funds at risk for embezzlement by someone who is experiencing a financial crisis.
- Apartment complexes and rental unit landlords will also check your credit history. Most won't rent to someone with a poor credit history because they view it as an indicator the person is likely to fall behind on paying their rent.
- Another good reason to improve your credit history and score is to get better interest rates on future credit. Most lenders used risk-based pricing. What this means is that borrowers with good credit histories get more attractive rates. The better your credit score, the lower your interest rate might be.
Three types of loans
With a traditional unsecured loan, you borrow money from a lender and pay it back at a predetermined rate and period of time. Since there's no collateral backing the loan, the financial institution is taking a risk by lending you money. To offset the risk, your interest rate might be higher than a loan backed by collateral, such as a car or house.
The risk of lending to someone with a bad credit history is much greater, and charging a higher interest rate doesn't always offset the risk.
However, financial institutions want their customers to successfully and responsibly manage their credit obligations, so they can lend to them and make money on the interest charged. That's why many credit unions and community banks offer credit builder loans. They allow customers with poor credit histories to demonstrate that they can responsibly manage their credit, so institutions can offer them traditional loans in the future.
There are two types of loans that help build credit. The first is a secured loan. With this type of loan, you use the money you already having in a savings account as collateral. Until you repay the loan, you cannot access the portion of your savings securing the loan. The interest rates on secured loans are usually lower than rates charged on unsecured loans.
Not everyone has a savings account they can pledge as collateral, so that's where true credit builder loans come in. The financial institution fronts you the money that you can have once you've paid back the loan.
Finding the right loan
Before you apply for a loan, make sure it's the right option for you. Shop your local financial institutions and find out their interest rates. Determine whether you need to pledge collateral.
When you find a loan you think is right for you, understand the terms of the loan, such as the number and amount of monthly payments, before signing the loan agreement. Be sure there's no pre-payment penalty if you repay the loan in full early. If you choose a credit builder loan, make sure the lender reports to all three of the major credit bureaus.
Credit builder loans are a great way to show lenders that you can manage a loan responsibly. You may not have access to the funds until you repay the loan, but you're taking the first steps to repairing and rebuilding your credit history and score.
To learn more about credit builder loans or other credit-related issues, contact us online or call us at 804-266-2767.