Getting loans, credit cards and other types of credit can be difficult for borrowers without a good credit history.
Trying to get approved for credit can be a sort of Catch-22: Creditors want proof that you’ve handled a credit card well before, but without a credit card already in hand it can be hard to show you’re a good risk.
Credit-builder loans can help. Using a credit-builder loan well can improve your credit score, though it can take a year to do it. That may be OK if you don’t need a credit card or mortgage immediately, but if you need credit now or are shopping for a house, a year can be a long time to wait.
Credit-builder loans are mainly offered by community banks and credit unions as a way to give borrowers a chance to show they can make regular payments and complete a loan, and ultimately be able to build or rebuild a positive credit history.
The loans are very different than rapid rescoring, which is a way to boost a credit score by 100 points in a few days as a way to be approved for a mortgage.
The loans aren’t about having a need for the money being loaned, but to improve a credit score.
Loans range from $500 to $1,500, with some as high as $5,000. Payments are usually from six months to a year. Interest rates vary and lenders may return a portion of the interest charges.
The lender puts the payments from a traditional credit-builder loan into a savings account or certificate of deposit, which may earn interest and is given to the borrower when the loan is paid off, usually within a year. Borrowers won’t have access to the money over the length of the loan, such as 12 months.
To be clear — you don’t get the loan amount when closing the loan, as you would with a traditional loan, but get the money from the credit-builder loan when you pay off the lender completely.
People who are trying to establish credit or rebuild credit after such major problems as bankruptcy may want a credit-builder loan. Or the loans can help people trying to build credit for the first time in their lives, such as recent college graduates, the newly divorced or immigrants new to the country.
Recent college grads, for example, who don’t have credit cards can use a credit-builder loan to establish a positive credit history and then have an easier time renting an apartment or getting a mobile phone account. These types of first-time borrowers will likely see a bigger boost in their credit score than someone who’s rebuilding their credit.
A source of income that allows monthly payments of $50 to $100 for the term of the loan is needed. Having unresolved financial judgments can make it difficult to get a credit-builder loan.
If you have unresolved financial judgments against you, it can be difficult to get a credit-builder loan. Pay those debts off first before applying for one.
The best place to find such as loan is at a community bank or credit union, where you’ll likely have to be a member.
There are more than 5,600 credit unions across the country, and finding one near you that you can join shouldn’t be difficult. An online credit union finder can help.
The loans don’t make much profit for lenders, so don’t expect a financial institution to offer them widely or to see them marketed. You may have to ask banks and credit unions of they offer the loans. They may use them as a way to get you in the door as a customer, with the hope that you’ll graduate to car loans, mortgages and other services that they can profit from.
Before getting a credit-builder loan, make sure the lender will report the loan to all three major credit bureaus. If it only reports to one, there will be less impact from paying off the loan.
A credit history is just part of what makes up a credit score. A longer credit history will increase scores, accounting for about 15 percent of a score. The history includes how long specific credit accounts have been established and how long it has been since the accounts were used.
Opening too many new credit accounts at the same time can hurt a credit score, with new credit accounting for about 10 percent of a FICO score.
Ultimately, credit-builder loans can lead to getting unsecured credit cards and then an installment loan such as a car loan within a few years to help build a strong credit history. And then, with a good or excellent credit score in hand, you’re more likely to get the best loan rates and possibly the best credit cards as lenders seek out your business.
Aaron Crowe is a journalist who specializes in personal finance. He has written for AOL Real Estate, HSH.com, US News & World Report, Wisebread, LearnVest, AOL Daily Finance, AARP, Wells Fargo, Allstate, the USC Marshall School of Business, and Credit.com, as well as other insurance, credit and investment websites. Check out his website at AaronCrowe.net.