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Companies offering credit builder loans have grown in popularity and boast that they can build or rebuild your credit quickly, but how exactly do they build your credit? More importantly, what kind of results can you reasonably expect?
I recently just wrote about how credit builder loans compare to other loans. Unless you are among the 1.2% of Americans who have a perfect 850 credit score (according Experian’s 2019 Consumer Credit Review), there’s room to improve, and these loans could be an option (though, admittedly, they are typically geared toward people with lower scores).
So, if you are seriously considering joining the millions of consumers who have built or rebuilt their credit score with such a loan service, you need to understand the basics of how these loans can boost your credit. While you certainly don’t need to understand all the technicalities, a basic understanding will help you more effectively utilize this option. In addition, such knowledge should also help you better understand how credit scores, which are often confusing and counterintuitive, work in general.
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Consumers with bad credit should both know their score and know how to improve it. The key point I’ve often preached in my 25 years of covering the credit industry is that obtaining a high credit score can be financially empowering and is an important building block in achieving financial success.
How credit builder loan payments build your credit
Credit scores have notoriously complicated algorithms. Fortunately, there are some basic components of scores that are fairly easy to comprehend.
Your payment history is one of the main factors that influence your score and the impact is pretty straightforward. If you get a credit card or a loan and aren’t late or miss any payments, it shows the three major credit bureaus that you are making on-time payments, month after month.
Remember, credit builder loans are those for which you typically pay an agreed upon amount to a lender and then receive the money back after you’ve met your obligation. Assuming the lender reports to the credit agencies, you are able to show regular, on-time payments.
Since payment history accounts for 35% of your credit score (and is arguably the most important part of your score), making on-time loan payments is a very big deal according to Donna Freedman, a longtime personal finance journalist and author of the “Your Playbook for Tough Times” books.
In summary, the process involves the following steps:
- You pay your credit builder loan in a timely manner every month.
- Your lender reports your monthly payments to the three major credit bureaus so the payments reflect on your credit report with each bureau.
- Your credit score increases as positive payment history accumulates on your reports.
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You can combine credit builder services with other credit building products, such as secured credit cards, in order to help accelerate your credit score gains. In fact, a few financial institutions offer secured card products that connect to your credit builder account. Basically, your payments to your credit builder account serve as the security deposit for your secured card.
How credit builder loans improve your mix of credit
Having a healthy mix of credit is an important factor in your credit score. There are various types of credit, but let’s briefly look at two of the most common types.
- Credit builder, auto loans, most personal loans and mortgages are considered installment loans. Installment loans have a definite beginning and end date during which you pay a certain amount regularly to pay back your debt over a set period of time.
- Credit cards and lines of credit are revolvoing credit accounts. That means you use them and pay them down repeatedly as long as the account remains open. You have the ability to run up debt to a credit limit on these kinds of account.
Showing and using different types of credit accounts for 10% of your score.
“If you’ve already got one form of credit (that is currently reporting your payments to the bureaus), a credit builder loan adds another form – an installment loan – to the mix,” Freedman explains. “[Credit mix is] another 10% of your FICO score, which doesn’t sound like much, but it all adds up.”
Gerri Detweiler, credit and small business expert and co-author of Finance Your Own Business: Get on the Financing Fast Track further explains.
“Most loans are reported as installment loans, rather than as revolving accounts like credit cards,” Detweiler says. “For consumers who don’t have a car loan, mortgage or other type of installment loan on their credit reports, [credit builder accounts] can be a helpful way to add another credit reference to round out their credit history.”
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The length of your credit history accounts for 15% of your score. In general, the more payments you make on your loan, the longer your credit history becomes. Many lenders offer the option to have a loan term (or length) of up to 24 months, which will help you establish a good credit history.
On a related note, FICO, a leading scoring model, states that if you don’t have a credit history, your loan must be open for at least six months in order for you to receive a valid credit score.
What are the downsides of credit builder loans?
While credit builder loans can certainly help you build or rebuild your credit, there are potential pitfalls you should consider.
For instance, you don’t receive money upfront, but rather have pay off your loan in full to get your funds.
“On the bright side, having to wait for the money might teach better money management,” Freedman counters. “You have to arrange your budget to allow for an on-time payment without fail.”
Freedman cautions that you also need to make sure you can swing your monthly payments. At least one company allows you to temporarily set the monthly amount owed to “zero dollars” in case you can’t make your payment one month. But don’t rely on this brief reprieve long-term; it could tempt you to fall behind on your obligations going forward.
The Consumer Financial Protection Bureau (CFPB) further cautions that “consumers who do have debt may want to consider paying down other loans before opening a [credit-builder loan] to help them build credit.”
Having an emergency fund is a good idea. Such an account serves as a safety net when the inevitable unexpected expense crops up.
“As with any type of loan, if you can’t make your monthly payments on time, you will hurt your credit rather than help it,” Detweiler explains. “If you don’t have an emergency savings account, you may want to build one before committing to one of these programs.”
These services are not a “quick fix” and companies that promises you fast credit repair solutions are likely not reputable. Having said this, it doesn’t take as long as you might think to boost your score.
Your payments typically appear on your credit report within about 60 days of your payment due date. It ultimately depends on the timing of when your lender reports info the bureaus each month.
How much can a credit builder loan improve your score?
The speed with which your score increases as a result of a credit builder loan varies by lender.
CreditStrong is one lender that attempts to answer this question on their home page with the following blurb:
Your credit profile and your associated credit score are uniquely you. How quickly your credit profile improves and the impact on the score will vary, but the best thing you can do is make on-time payments and keep building your profile.
Remember, if you don’t even have a score yet, FICO often requires six months of payments before it will show a score. VantageScore can often generate a score within a month or two of credit activity, according to Experian.
“A study from the CFPB notes that a loan could add up to 60 points for borrowers who didn’t already have existing debt,” Freedman adds. “When factored into the average beginning credit score of 560, that could be an ‘economically meaningful change,’ since it would move the borrower from subprime (i.e. bad credit) to near-prime status (i.e. decent credit).”
Detweiler further points out that a lot of factors come into play.
“Many different factors go into credit scores, so your results may vary,” Detweiler explains. “If you already have installment accounts on your credit report that you’re paying on time, for example, you may not see as much of a boost as someone who lacks this type of account.”
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Even if you don’t achieve a 60-point increase, you can still make positive gains that are meaningful. Such gains can help you achieve financial success that could possibly save you thousands of dollars in interest charges and/or lower your insurance premiums.
And small gains are still gains! Your credit history and score will follow you throughout your life so it’s a marathon, not a sprint. Consistent responsible behaviors will postively affect your credit, even if it takes some time.
Final thoughts
I love the concept of credit builder programs and hope these insider tips educate and inspire you. I think these programs make the goal of having good credit more attainable for millions of consumers.
Having said this, you should still be proactive when it comes to building your credit and try to educate yourself on best practices.
The bottom line is that credit builder programs can assist you greatly with boosting your score, but they should not be considered a “hands-off” approach. Ultimately, the most effective way to build your credit is through education and responsible habits. Fortunately, there are a lot of free resources, like this article, that can assist you in this regard.
I would love your feedback on your personal experiences with credit building. Who knows, I may include a tip from you in a future article. Best wishes in using these services to your financial advantage!
