A Complete Guide on Credit Builder Loan and How it Works

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You need to have a good credit score to qualify for a credit card or a loan. But you also need a credit card or a loan sanctioned in your name to build a credit score. It’s a classic catch-22!

Finding a credit lender that can offer you loans can be hard, perhaps even impossible if your credit is less than stellar. So, in such instances, what can you do?

Avail of a credit builder loan!

What Is a Credit Builder Loan?

A history of timely payments made towards a loan or a credit card can help you build a good credit score. Eventually, it will make it easier for you to avail such loans with minimal interest rates. A credit builder loan is a way to help individuals with no, little, or poor credit scores to improve their numbers.

These specific loans are offered by credit unions and local banks. While you close the loan through consistent payments, the amount loaned by you is held in a secured account. The funds are released to you once the loan is completely paid off. Essentially, it can be considered as a loan to pay off debt that you have and improve your credit score simultaneously.

How Does It Work?

A credit builder loan is like any other regular loan. This means that the loan payments you make are reported to credit bureaus who manage your credit score.

Simply put, by closing off a credit builder loan, you can prove to banks and lenders that you are a trustworthy borrower and financially capable of paying off loans. Through these loans, you can qualify for personal loans such as credit cards, auto loans, and mortgages.

Advantages of a Credit Builder Loan

Apart from improving your credit history, a credit builder loan has several other advantages, such as:

  • It helps you save up; since you’re making regular payments into a secured account that will later be released to you.
  • It can help you stay financially healthy and improve your money management skills.
  • It prepares you to avail of larger personal loans in the future.

Nevertheless, before taking out a credit builder loan, ensure that the financial institution through which you’re availing the loan reports to all major credit bureaus rather than just one or two of them. This will help you receive all the benefits of a credit builder loan.

Disadvantages of a Credit Builder Loan

While the benefits of this loan are in abundance, there are a few disadvantages that you should watch out for, like:

  • Missing Payments: These delays will also be reported to the credit bureaus and will negatively affect your credit report.
  • Service Charges: These loans come with a price tag. Banks and lenders may charge extra fees, such as application fees and administrative expenses.

Missing a Payment

Missing payments on this loan will do the opposite of what you’re trying to achieve. Missing a payment on the loan, even by a few days, will negatively affect your credit score as your lender is obligated to report all your activities to the major credit bureaus. This will lead to a drop in your credit score and will blemish your report.

This is why you should only take out a credit builder loan if you’re absolutely sure that you can manage to make timely payments.

After Closing the Loan

Once all the essential payments are made to close your credit-builder loan, the funds will be released back to you. In certain instances, the lender may issue the funds along with the interest you paid, or after deducting an amount for any pending fees.

However, the terms and conditions differ from lender to lender. Hence, you must always find out about a lender’s policies, fees, and returning interest rate when choosing one. Typically, the money is directly sent to an account of your choice as a lump sum, after which the money is yours to spend as you see fit.

Closing a Credit-Builder Loan Early

Generally, you can choose to close off a credit builder loan in advance, and your lenders might even allow you to do this. However, this defeats the very purpose of taking out such a loan in the first place. By doing so, you are cutting the timeline for constructive payment history short, which is the opposite of what you want to accomplish to build credit.

There are several disadvantages to paying off a loan ahead of schedule. For example, if your funds are kept in a CD or Certificate of Deposit, you will have to wait to close the same and withdraw the money even though you’ve paid off the loan early. Additionally, you’ll have to shell out a penalty to gain your funds ahead of time.

The best course of action for such loans is to complete timely payments as per the loan term and not close it off early, and enhance your credit gradually just as you planned.

Fees Charged on Credit Builder Loans

Credit builder loans are significantly helpful. However, they can also be quite expensive. Some of these loans may have high fees, which may include the following:

  • Administrative Fees: Typically paid before you qualify for the loan to process your request.
  • Annual Percentage Rate (APR): These loans can charge a significant amount through interest. APR is the rate of interest these loans can charge. Generally, APRs for credit builder loans range from anywhere between 6% and 16%. These also depend on your lender’s rates and your creditworthiness.
  • Late Fee: When you miss a payment towards the loan, you may have to pay a certain amount on top of what you already owe. This is typically a percentage of the payment you missed.

The Bottom Line

Credit builder loans can help you get started on building a positive credit history. It can get you the approval of banks and lenders with respect to credit cards, mortgages, and auto loans on better terms, conditions, and interest rates in the future.

Nevertheless, it is crucial to make timely payments and continuously monitor your credit score improvements to accomplish what you set out to achieve with this loan. If used carefully, credit builder loans can be your first and greatest step toward building a strong and reliable credit history and being financially healthy.

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