What is the purpose of a credit builder loan?

Curtis Arnold
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Curtis Arnold
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How can a credit builder loan help me and how does it compare to other loans?

“Credit builder” loans have grown in popularity in recent years and seem to be getting more and more media exposure.  These loans promise a quick and cheap way for consumers to rebuild or build their credit. Despite the growth, however, there is a lot of confusion about how these loans actually work.

Certainly, the phrase “credit builder” implies that the loans are designed to build your credit. But, how exactly do they work and how long have they been around? How do they compare to other loans? Do they have other not-so-obvious benefits and purposes?

Are you one of the 100+ million U.S. consumers who, according to Experian, have low or no credit? You should thoroughly understand basics about these loans before jumping on the bandwagon.

Learn the basics so you can make an educated decision as to whether such a loan fits your financial situation. Simply put, an educated consumer in an empowered consumer!

How does a credit builder loan compare to other loans?

One of the best ways to explain a credit builder loan is to compare it to other personal loans. Here are some of the most notable differences:

  • With a traditional loan, you typically get money you’re borrowing upfront and pay it back over time (with interest).

Credit-builder loans work differently, though. You make fixed payments to a lender and then access the loan amount at the end of the loan’s term. Terms vary, but are often 12-24 months in length.

  • The credit score required to qualify for traditional loans is normally much higher than that required for credit builder loans. In fact, you can often qualify for a credit builder loan with bad/poor or even no credit.

“Both kinds of loans can help build your credit,” explains Donna Freedman, author and longtime personal finance journalist. “But you don’t already need to have good credit to get a credit builder loan. To get an unsecured personal loan, you need either good credit or be willing to pay a much higher interest rate for a personal loan if you have bad credit.”

Gerri Detweiler, author and credit and small business expert, adds:

Credit builder loans can have a similar impact as personal loans in terms of building your credit, but you don’t need good credit to qualify. And, unlike a personal loan for [someone with] bad credit, the cost of the loan won’t be sky-high due to the higher risk [that the lender takes on with a traditional loan].”

BONUS TIP!

A secured credit card is also a great way to build or rebuild your credit. Some credit builder companies actually offer secured cards as well, generally associated with a credit builder account. Read my recent article that explains the differences between secured cards and credit builder loans for more info.

Are credit builder loans new?

Several companies that offer credit builder loans online promote themselves as being new financial technology (FinTech) companies. They typically offer cutting-edge technologies, such as snazzy apps that can track changes in your credit score.

Proponents praise the technologies. Some even think these loans have the potential to turn the credit industry on its head. Such proponents even go so far as to say that we are seeing a paradigm shift in the credit industry.

Interestingly enough, though, these type of loans aren’t new, but rather have been around for decades. According to Self, the company that helped pioneer the concept of marketing credit builder loans online, such loans have historically been available in limited areas by some community-based organizations (CBOs), credit unions and local banks.

A key benefit of credit builder companies like Self is that they can aggressively promote these loans online. As a result, they haven’t been limited by traditional brick and mortar banking and can appeal to a national audience.

BONUS TIP!

Some companies offer the ability for you to also build credit by paying your rent, cell phone bill or utilities payments. Typically, such payments aren’t reported to the three major credit bureaus and, therefore, won’t help you build your credit. You can, however, pay a monthly subscription fee to have them reported.

Self Financial CEO James Garvey founded the Self credit builder program in 2015 after his personal struggles with credit. Now, less than 10 years later, Self claims to have helped over 4 million consumers boost their credit score.

Consumers that utilize such services to build or rebuild their credit often are looking for cost-effective solutions that are consumer friendly. Moreover, as noted above, offering such services online has made these services convenient and available to pretty much every consumer.

quote

They’re a way for pretty much anyone to begin building credit, or repair existing credit — even if they can’t get a credit card or any other kind of personal loan

Donna Freedman,
personal finance journalist and author

Detweiler goes a step further, pointing out credit builder loans have a dual purpose.

“Credit builder loans offer a double benefit (that traditional usually loans don’t): Build credit and savings at the same time,” Detweiler says. “They offer a relatively low cost and low risk way to build credit.”

BONUS TIP!

Credit builder loan providers typically hold your funds in a savings or CD account in your name. The balance in this account grows each month as you make payments. Some services actually pay you interest on the amount you deposit into your savings account, which can help offset any fees or interest. Additionally, some credit builder loans form the foundation for secured credit card deposits.

Credit builder loans remain poorly understood

There are now several large players in the credit builder loan space. They all claim the ability to do wonders for your credit score, especially if your score is lower than average. Yet, despite their popularity and the measurable results, there seems to be a lot of confusion and a general lack of consumer awareness regarding credit builder programs.

FIRSTHAND ACCOUNT: Anecdotally, I mentioned these loans to a friend that has a low score. She was confused about what exactly they were. After describing the benefits to her, she said she was already enrolled in a program. Turns out, she actually just has a credit card that promised to build her credit.

– Curtis Arnold,
CardRatings contributor

I have interacted with hundreds of consumers that have had a low credit score and many of those consumers have felt hopeless. This hopelessness is fueled by a lack of consumer awareness. Life happens (many low scores are due at least partially to medical debt for example) but don’t let a poor score stress you out!

It is truly amazing how quickly your score can increase when you utilize these services effectively. The key word here is “effectively,” and this is why it’s important to thoroughly understand how these services work before you commit your hard-earned money.

There are certainly other legitimate ways to build your credit using helpful approaches that are fairly easy to manage and are affordable. Be sure to look at your options and avoid costly credit repair companies if at all possible (many of which are not consumer friendly)!

Credit builder loans can provide a path to credit cards

One of the main goals for many consumers that utilize a credit builder loan is to get approved for a secured credit card, which are additional tools that can help improve your score. You may be surprised to know that secured cards do not approve all applicants… even though you use your own money to secure your credit limit or credit line.

Fortunately, some loan companies make getting a card convenient as they offer paths connecting a credit builder account to a secured credit card.

Take CardNamediscontinued, for instance. With Chime, you open a chiecking account and fund it with a qualifying direct deposit of at least $200. Once you’ve done that, you can qualify for secured card without a credit check or minimum credit score. In this case, the money you’ve put in your checking account serves as the security deposit to establish your line of credit on the secured card.1 To apply for Credit Builder, you must have received a single qualifying direct deposit of $200 or more to your Chime® Checking Account. The qualifying direct deposit must be from your employer, payroll provider, gig economy payer,or benefits payer by Automated Clearing House (ACH) deposit OR Original Credit Transaction (OCT). Bank ACH transfers, Pay Anyone transfers, verification or trial deposits from financial institutions, peer to peer transfers from services such as PayPal, Cash App, or Venmo, mobile check deposits, cash deposits, one-time direct deposits, such as tax refunds and other similar transactions, and any deposit to which Chime deems to not be a qualifying direct deposit are not qualifying direct deposits.

Final thoughts

I personally love the concept of credit builder programs and hope this primer has helped you understand the purpose and goals of these unique loans. These loans have made the goal of having good credit more attainable for millions of consumers. Furthermore, these loans are a cost-effective and convenient way to build or rebuild credit.

“It’s a fairly low-risk way to help build your credit, and at least you can end up with a savings account,” Detweiler says.

I would love your feedback on your personal experiences with building credit. Who knows, I may include a tip from you in a future article. Best wishes in using these services to your financial advantage!

1Money added to Credit Builder will be held in a secured account as collateral for your Credit Builder Visa card, which means you can spend up to this amount on your card. This is money you can use to pay off your charges at the end of every month.

author
Curtis Arnold
CardRatings Founder

Curtis founded Cardratings.com in 1998 and, in so doing, helped pioneer the concept of rating credit cards. He has been a nationally recognized expert in consumer credit for well over 20 years. He is the author of “How You Can Profit from Credit Cards: Using...Read more

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