Building good credit is an important part of financial health. A strong FICO score can open doors to lower interest rates on loans, increase your credit limit, and even help with renting an apartment or getting a job.
On the other hand, a bad credit score can leave you with higher interest rates, denied credit applications, and rejected apartment/job applications. If you currently have a low credit score, then don’t worry. The good news is that there are plenty of ways to build it up.
One effective tool that's gaining popularity for improving credit is the credit-builder loan. This article provides a comprehensive guide to understanding credit-building loans and how they can help you improve your credit score.
What are credit-building loans?
A credit-builder loan is a calculated financial tool designed to help individuals establish a solid payment history and either build credit or revamp their existing credit score. This is a unique type of installment loan, as it doesn't operate on the broad principle of most loans where you receive the loan amount up front.
Instead, the lender deposits the loan amount into a secured savings account. This amount stays locked away from your immediate use. Your responsibility, as the borrower, is to make monthly loan payments toward the total loan balance.
The purpose of this credit-builder account is far beyond the deposit-return function — it's to demonstrate your ability to make consistent, on-time payments. This ability to make regular and punctual payments is a key factor in building a positive credit history and, in the process, achieving a higher credit score.
How do credit-builder loans work?
Initiating a credit-builder loan starts by applying for the loan at a financial institution such as a bank or a credit union. Upon approval, the lender doesn't hand you the loan amount in cash or direct transfer as most would expect.
Instead, the lender sets aside the loan amount in a secured savings account. It is important to understand that this amount acts as collateral and is inaccessible until you've successfully made all your repayments.
One of the significant aspects of this loan is the effect that your monthly payments have on your credit score. These payments, once made, are reported to the major credit bureaus — Experian, Equifax, and TransUnion. Consistent on-time payments made toward the remainder of your loan balance can have a positive impact on your credit score.
At the end of the loan term, the circle completes — you will have not only begun to build a solid credit history but also saved up the loan amount. The funds, minus any interest and fees, are then returned to your bank account. If done right, you may also have a higher credit score.
What are the benefits of credit-building loans?
The most significant advantage of using a credit-building loan is building a positive credit history.
A second advantage is the lower risk of falling into debt. Since the loan amount is not immediately accessible, you're not likely to add anything to your existing debt from the loan. Instead, you’ll find yourself with a lump sum of savings!
The credit-builder loan model challenges the traditional approach to loans and offers a unique solution to credit building. It combines the discipline of regular savings with the added benefit of improving one's credit score. It's a powerful tool for anyone seeking to start or rebuild a solid credit history.
So, when thinking about your credit score, remember that borrowing money is not the only solution — sometimes, the right loan product can make all the difference.
How are credit-building loans different from traditional loans?
It's important to understand that credit-builder loans are different from traditional loans.
For starters, the approval of a traditional loan is typically based on your credit score, payment history, credit utilization rate, and a few other key factors. The better these are, the more likely that you’ll get approved.
A credit-builder loan, on the other hand, typically doesn't require a good credit score or even any credit score at all, making it more accessible, especially to those new to credit or those looking to rebuild their credit.
Another distinguishing factor is the interest rates. While personal loans may have relatively high annual percentage rates, credit-builder loans usually offer lower rates. The lender is taking on virtually no risk with a credit-builder loan, so there’s no need to offset with a higher interest rate.
Furthermore, the purpose of a credit builder loan differs from a traditional loan. It's more focused on credit building rather than borrowing money for an immediate expenditure, making it a powerful tool for long-term financial wellness.
Where can you get a credit-building loan?
You can find credit-building loans in many places, ranging from community banks to federal credit unions or even online lenders. These financial institutions are your best bet when it comes to credit-builder loans.
An important factor here is to ensure that the lender reports to the three major credit bureaus to ensure your payments are positively affecting your credit score.
Naturally, be sure to compare interest rates and fees to ensure you're getting the best deal. Credit-builder loans can be helpful, but they’re not free.
What are the risks of a credit-building loan?
Like any financial product, credit-builder loans do have some risks.
The most significant risk is the effect that making late payments can have on your credit score. Late or missed payments can severely negatively impact your credit score and show up during credit checks for years, undermining the very purpose of the loan.
Some lenders may also charge high fees, so it's essential to understand the fine print of your loan agreement. Stay clear of any financial services that promise unrealistic results, and always do your due diligence.
Are there other options to build your credit?
Apart from credit builder loans, there are other options to consider for building credit. These include:
- Secured credit cards: A secured card requires a security deposit, and the credit limit is typically the amount of the deposit. Responsible usage and timely payments can help build credit.
- Authorized user status: Being added as an authorized user on someone else's credit card can allow you to benefit from their good credit habits and possibly boost your score.
- Vital Card: Vital Card is an innovative credit card that rewards responsible spending habits. It’s an opportunity to take control of your personal finances and achieve financial growth, and it can be a useful tool in your credit-building journey.
Credit-building loans offer a viable strategy for those looking to improve their credit scores. Regular, on-time payments can help you build a strong credit history while also encouraging you to save.
Consider your options carefully, and choose the best credit-building strategy that suits your financial situation.
And while you're at it, don't forget to join the waitlist for Vital Card. You’ll be rewarded for good spending habits and you can work on building your credit at the same time.
What Is a Credit-Builder Loan? | Equifax
What Is a Personal Installment Loan? | Consumer Financial Protection Bureau
How to Improve Your Payment History | Experian
Credit Reporting Agencies | TransUnion
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.