Having poor credit can turn your financial world upside-down. You could face unfavorable loan terms, credit denials, even difficulty qualifying for a lease or the best insurance rates.
A December 2020 Credit Sesame survey, however, noted that the cost of a poor credit score goes well beyond finances and can impact almost every area of your life, including your mental health, personal relationships, living situation, employment, etc.
Fortunately, several innovative products and tools have surfaced recently to help consumers build or rebuild credit in a relatively short time frame (think several months instead of several years). One such product is commonly called a credit builder loan or a "backwards loan."
The interesting name "backwards loan" refers to the fact that these loans don't give you the money up-front as is typically the case with a loan; instead, you make payments on the loan FIRST and receive the money at the end of the loan. This type of loan is turning traditional bank lending on its head and growing in popularity since they provide protection for lenders as well as opportunities for borrowers to increase credit scores without taking on mounds of additional high-interest debt.
As with any loan product, however, there are advantages and disadvantages to consider before you jump on the bandwagon. After all, an educated consumer is an empowered consumer!
It is my hope that the following "insider tips" can assist you in determining whether a credit builder loan is a good fit for you. Special thanks to my long-time colleague Beverly Harzog, a consumer finance analyst with U.S. News and World Report and author of "The Debt Escape Plan: How to Free Yourself from Credit Card Balances, Boost Your Credit Score, and Live Debt-Free" for help with this article.
First, let’s clear up the major differences between credit builder accounts and another common product used for building credit: secured credit cards.
What’s the difference between a credit builder account and a secured credit card?
Credit builder accounts don’t actually give you access to loaned money; their purpose is to help you build credit by showing good payment habits, but they aren’t going to help you if you’re in need of immediate cash for an emergency. You can technically only spend money that you’ve already put in the account. For example, if you deposit $100 into your credit builder account and then use a linked debit card (or secured credit card as we discuss below) to make $99 in purchases throughout the billing cycle, the credit builder service will report to the credit bureaus that your balance was paid in full that month.
A secured credit card, on the other hand, does allow you to borrow against a line of credit – albeit, one that you “secured” with a deposit. Still, even though the account is secured by your own money, that deposit can’t be used to pay your balance each month and banks will charge you interest if you don’t pay the balance off in full.
Both products allow you to build credit with responsible use and payment, and can work well together.
Credit builder accounts vs. secured credit cards
|Credit builder||Secured card|
|Requires initial deposit||No||Yes|
|Allows access to line of credit||No||Yes|
|Allows you to build credit with responsible use||Yes||Yes|
|Charges and annual fee||Rarely||Often|
|Requires hard credit pull to apply||Rarely||Usually|
|Impacts credit utilization||No||Yes|
Should you choose a credit builder account or a secured credit card?
Credit builder accounts and secured credit cards serve different purposes, so why not consider both?
The first thing you should do before applying for any financial product is get your credit score and make sure you know what lenders consider a good credit score. Once you've determined that your credit isn't in great shape, you might be asking yourself if it's better to build your credit with a secured credit card or with a credit builder loan. There are many different options, so the process can be confusing. On a related note, please note that credit builder accounts/loans or services are very different than credit repair services (of which I am not a big fan).
The good news is that credit builder accounts and secured credit cards can work hand-in-hand, so you can have your cake and eat it too!
There are several financial institutions that now offer credit builder services in combination with a secured credit card, which could truly be the best of both worlds for a lot of people looking to build credit quickly, but also enjoy the convenience of a credit card.
To better understand the pros and cons of each option, let’s take a look at two of the biggest credit builder options out there: Chime Capital, which boasts 13 million members, and Self Financial, which has served over 2 million members since its inception. Both also offer secured credit cards connected to their credit builder products.
Chime vs. Self: The basics
Think of cards offered by Chime and Self as new and improved secured cards.
In addition to a debit card tied to a credit builder account, Chime offers the Chime® Credit Builder Secured Credit Builder Visa® Card that targets those who are either establishing or rebuilding credit. Similarly, Self offers the Self - Credit Builder Account + Secured Visa® Credit Card.
The benefits of both offers are significant. This is especially true when compared to other secured cards or to an unsecured credit card that markets to consumers with bad credit (can we say high fees and low credit lines!).
For starters, the Chime card doesn’t charge an annual fee, which is unusual among secured cards. Self charges an annual fee of $25, which is still reasonable when compared to other offers.
One of the most attractive features of Chime, though, is that is does NOT charge any interest or finance charges on purchases made with the Chime card since your account balance automatically pays off the card balance each month. This is particularly amazing considering that most secured cards charge high interest rates, often in the 20%-25% or more range.
On the other hand, Self does charge interest on balances that aren't paid in full and does not use your credit builder savings account balance to pay your balance – you’ll need to manage that separately. The interest rate or APR for Self is 23.99% (This APR will vary with the market based on the Prime Rate), which is about average for a secured card.
With the Self card, though, it’s two different forms of credit that are reported to the credit bureaus: an installment loan for your credit builder account and a credit card (revolving credit) for your secured card. The credit bureaus reward responsible handling of multiple kinds of credit accounts, so this could work in your favor.
Can you qualify for a credit builder account or secured card?
No one wants to be denied credit. Fortunately, secured cards offered by Chime and Self offer guaranteed approval as long as you meet their stated requirements.
It may be hard to believe, but not everyone gets approved for a traditional secured card despite the fact that the lender is using your own money as collateral to open your account! A unique feature of Chime and Self is that neither checks your credit, also known as a “hard credit pull,” when you apply.
Hard pulls, which are normally required when you apply for a secured card (or any other credit card for that matter), can temporarily lower your credit score.
The bottom line is that since Chime and Self don't check your credit when you apply, they guarantee approval once you meet certain criteria.
Is a security deposit required for the Chime or Self secured cards?
Worried about having to fork out $200-$500 for a security deposit? Chime and Self have you covered.
Most secured cards require you open your account with at least a $200 security deposit. This initial deposit, which is also usually your initial credit limit, can be a tough hurdle for some consumers to overcome, especially when that amount isn't then available to cover purchases made with your card.
In contrast, Chime doesn't require a minimum security deposit. Zero, zilch, nada! So, you can transfer as little as you want to your secured account to begin using your card. Note, though, that you must have at least a $200 direct deposit minimum in your Chime checking account to qualify for the secured card. That money you transfer can then be used to pay down your balance each month.
Similarly, Self requires a minimum deposit of $100 in your credit builder account before you can qualify for the secured card, but this is much lower than most secured cards.
The security deposits of most secured credit cards are not available to you, the consumer, until you close your account. Chime, however, allows you to use your deposit to actually pay for your monthly charges. Now there's a novel idea! It’s also the reason you won’t pay interest on your charges.
Is a credit builder account good for building credit?
Bummed about your low score? Chime and Self members claim you can see 30-60 point increases in your score in a few months!
Like most other secured cards, Chime and Self report your monthly payments to all three credit bureaus, which is a proven strategy that can help build your credit score over time. However, the specific claims by Chime and Self definitely aren't made by any other secured cards that I know of.
Case and point, based on a representative study conducted by Experian, Chime members who made their first purchase with the Credit Builder Card) between June 2020 and October 2020 observed an average FICO Score 8 increase of 30 points after approximately eight months.
Needless to say, this is quite impressive, but is this really realistic for most card members or more of a marketing gimmick to get consumers to sign up?
"I think it's both," Harzog notes. "It will help boost some consumers, but people need to have realistic expectations. If you're coming back from very bad credit, it might take longer. It's best to focus on paying your bills on time and keeping low utilization ratios on credit cards. The bottom line is that great credit habits are the road to a great credit score."
Clearly, credit scores are complicated and a lot of factors can influence your score. The Consumer Finance Protection Bureau (a federal oversight agency), for example, also conducted an interesting study of credit builder loans in 2020. This study showed that the credit scores of those participants without existing debt increased by an average of 60 points higher than participants with existing debt.
"The actual impact on your score is dependent upon the details in your credit report," Harzog adds. "But I do like to recommend credit builder loans to those who are trying to build or rebuild credit. It's a good choice for someone who can't get approved for a credit card. It's also a good choice for someone who can't – or doesn't want to – use credit cards."
With most credit cards, high credit utilization can lower your credit score; however, Chime doesn’t report your credit utilization because it doesn't have a preset spending limit. In other words, you set your credit line (with your own money). As a result, you don't have to worry about a high utilization rate on this card hurting your credit.
How to get a credit builder account or secured card
There has to be a catch, right? Well, you do have to meet certain criteria to gets these cards.
One thing that makes these two offers different is that you can't apply right away for their secured cards. Chime, requires you to open a checking account with them and get their debit card before you can get their secured card; then, that secured card functions as your credit building account. Chime customers can use the debit card as you would any checking account-tied debit card, including withdrawing from your account via more than 60,000 ATMs. Once you’ve receive a qualifying direct deposit of at least $200, you’ll be eligible to open the credit builder account and, subsequently, the secured card.
Self requires you to open an account with them, which generates a small backwards loan (fees and interest apply). You then must make three monthly payments on time (payments are as low as $25 a month) and have $100 or more in savings before you can apply for the secured card.
While these offers aren't a scam, they are more complicated than traditional offers so you need to make sure you understand how they work before you take time to apply.
"With any credit product whether traditional or new and innovative, you need to read the terms carefully so you what fees they charge,” Harzog emphasizes. “For example, Chime charges a fee for ATM withdrawals made outside their network. Track your expenses and stay within a budget."
I sincerely hope this explanation of credit builder vs. secured credit cards, with the Chime and Self offers as examples, is helpful and would love your feedback on how you've used credit cards to help rebuild or build your credit. Who knows, I may include a tip from you in a future article.
Good luck boosting your credit score – it's not as hard as you might think and can actually become quite addictive as your score rises!