Can Credit Building Loans Really Help You Build Credit?

can-credit-building-loans-really-help-you-build-credit?

When you don’t have any credit history or your credit score is on the low side, common wisdom says to get a loan. With a new loan, you should be able to make payments and improve your score over time, right? Unfortunately, you can’t always just “get a loan” in the real world, and that’s especially true if your credit is nonexistent or really bad.

Secured credit cards have long been a good solution for consumers who need to improve their credit but can’t get approved for a  loan. With a secured credit card, you put down a cash deposit as collateral and you get access to a line of credit you can borrow against. Your credit card payments are reported to the three credit bureaus, and you get the chance to improve your credit score over time as a result.

Interestingly, another type of loan product for bad credit has made its way onto the market over the last decade. Credit builder loans work similarly to secured credit cards since they let consumers secure their own loan and make monthly payments that are reported to the credit bureaus. But, do credit builder loans really help?

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A Closer Look At Credit Building Loans

According to Michael Broughton, CEO & Founder of Perch Credit, which helps consumers build credit using their rent payments, credit building loans can absolutely help consumers improve their credit scores. 

Take the credit builder loans or “credit building savings accounts” from Self, for example. With Self, you apply for a credit builder account, agree to monthly payments, and eventually pay off the amount you agree to. Plus, you get all the money you paid back in the end, less any fees.

“These types of loans help build your credit because the lender will report each of your successful payments to the three major credit bureaus,” says Broughton. “Given that the biggest impact on your credit score is payment history, over time the payments you make on these credit builder loans will increase your credit score.”

A credit builder loan can also be a great way to jumpstart your credit journey if you have little to no other credit history, he says. 

Adem Selita, CEO & Co-founder of The Debt Relief Company says the good thing about credit builder loans is that you can apply for a very low balance credit builder loan with low monthly payments. Since accounts from Self come with monthly payments as low as $25, this means most people can afford to build credit this way.

From there, payments to a credit builder loan offset the negative impact of any missed or late payments you’ve had in the past. Also, the act of completely paying off the credit builder loan on time will provide one more instance in which you demonstrate financial responsibility, which shows that you’re a good credit risk. 

Even the Consumer Financial Protection Bureau (CFPB) agrees that credit builder loans can be a boon for consumers who need to build credit. According to a CFPB report, those who applied for one without an existing loan increased their likelihood of a good credit score by 24%. Not only that, but participants who took out a credit builder loan without any existing debt saw their credit scores increase by 60 points more than participants who had existing credit history and debt.

Further, credit builder loans work as a forced savings account. Based on this fact, users profiled by the CFPB said they increased their savings balance by an average of $253.

Credit Builder Loans: What To Watch Out For

For the most part, credit builder loans are pretty cut and dry. You agree to pay a specific amount each month, and the company that provides the “loan” saves that money for you in an account. They report each of your monthly payments to the credit bureaus and, over time, your score goes up. In the end, you’re rewarded with the money you paid to the account during the loan period. 

So, what’s the catch?

Broughton points out that, while a credit builder loan can in fact build credit over time, it does cost the borrower something. Take the credit builder loans from Self, for example. This provider is very transparent about the costs involved in their product, yet their numbers still show that nothing is free.

With Self, you could agree to pay $48 per month and a $9 upfront fee to get your account started. From there, you would pay $48 per month for 12 months. Once that year was over, you would receive $539 back — or $46 less than you paid in.

Another company in this space, CreditStrong, offers a similar fee structure. In their website example, you pay an upfront administrative fee of $8.95 to get your account started. From there, anywhere from 88% to 98% of your payment is applied to your account each month, the rest going to fees.

That’s not a lot of money to lose to build your credit, but it’s still worth noting.

One other “gotcha” with credit builder loans is the fact they may not work in your favor if you go through a rough patch. If you make late payments on your credit builder loan, those are reported to the credit bureaus as well. 

This means that, instead of having your on-time payments improve your credit score, late payments to a credit builder loan can actually make your credit score worse than it is. And if you started your credit builder loan because you had no credit history, you’ll definitely be starting your credit journey off on the wrong foot. 

That’s why credit builder loans should only be used by people who are serious about their credit goals and ready to commit. James Garvey, CEO and co-founder of Self, says that loan products like the ones Self can be a great entry-level tool for someone who wants to build credit from scratch or after financial hardship. After all, you get the chance to establish positive credit habits while working toward goals like buying a house or paying for college

“Like any tool though, in order for credit builder loans to help, you have to use them responsibly,” he says.

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