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Credit builder loans are small, safe loans that will give you a way to build credit from scratch if your score is low.
They’re made for people with debt or lower scores, so if you’re having trouble getting a credit card or auto loan this might be just the thing for you.
What is credit and what’s a credit score?
Credit is basically your ability to borrow money. That doesn’t just mean getting a loan, either.
Financial institutions use a thing called a credit score to decide if they should offer you credit (read: a loan, a credit card) or not.
That credit score is usually calculated off of five different things:
- Your payment history. This looks at whether or not you’re paying things on time and in full.
- How much credit you have available. Financial institutions want to see that you’re not using the bulk of your credit. Generally, try to use less than 30% of your available credit. So if you have a credit card with a limit of $10,000, try not to have a balance of over $3,000 at any given time.
- Your credit history. The longer you’ve had credit, the more financial institutions feel like they can trust you with it.
- Your credit mix. To see that you’re good at your all-around money management, financial institutions like to see a mix of credit types. That could mean having a couple of credit cards, a car loan, and a mortgage, for example.
- Limited new credit. If you open a bunch of new lines of credit in a short time, it makes you look like you’re strapped for cash. And that’s a red flag for financial institutions.
Some of these things—like your payment history and available credit—get weighed more heavily.
How credit builder loans work
When you take out a credit builder loan, you don’t get the money right away. Instead, the lender holds onto the money.
These loans are usually small, as are the monthly payments and the loan term (i.e., how long the loan lasts).
Most credit builder loans come in increments of somewhere between a few hundred to a few thousand dollars. The loan term is usually between six months and a couple of years.
Say, for example, you get a credit builder loan with a two-year loan term and monthly payments of $25. For two years, you pay the lender $25 a month.
Keep making those payments anyway. Then, at the end of the two years, you get two things.
First, you get the loan money. It’s cash you can put into an emergency fund or wherever you need it.
Secondly, you get a better credit score. By paying on time over your loan term, you build payment history.
Is a credit builder loan right for me?
All told, credit builder loans can be ideal if you don’t have any or much credit to your name.
It’s low-risk for the lender because they hold onto the money until you’ve paid it off. And it gives you a manageable way to learn good credit habits.
If you already have quite a few credit lines and a bad credit score, a credit builder loan probably isn’t right for you, though.
The Consumer Financial Protection Bureau (CFPB) analyzed credit builder loans to find out if they work.
They found that for people with no credit score, these loans increased their likelihood of having a score by 24%.
For people with existing debt, the credit builder loan actually caused a decrease in their credit score. But those who didn’t have existing debt before getting the credit builder loan saw their credit score increase by 60 points over those with existing debt.
Ultimately, skip this loan if you have bad credit. But consider it if you have no credit.
Just remember that a credit builder loan isn’t going to give you amazing credit overnight. If you’re struggling to get credit or wondering where to start, though, it might be a good option for you.
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