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What is a Credit Builder Loan and How Does it Work?

credit builder loan

A credit builder loan is a financial product best suited for consumers without a credit score or those with low scores. They provide an opportunity for those just getting started to build credit or for those with a negative credit history to demonstrate a positive payment history.

Credit builder loans are typically not offered by larger banks and are more commonly offered by small financial institutions like credit unions and CDFIs.

Unlike traditional loan products, a Credit Builder Loan does not require a high credit score for approval, however, you will need to demonstrate sufficient income to make the loan payments.

Why Does Credit Matter?

Your credit and credit score is a pivotal piece of your financial life.  A credit score is calculated based on the information contained in your credit report. The most commonly used credit scoring model is a number between 300 and 850 known as your FICO score. This score helps future creditors determine your creditworthiness and has a large impact on whether you can obtain credit, the interest rates you can qualify for when borrowing, and more.

WHY DO YOU NEED CREDIT?

According to Justine PETERSEN a non-profit organization, and pioneer in the credit building industry.

People with good credit will save roughly $250,000 in interest and fees throughout their working lives.

Good credit increases your ability to purchase a home, start or expand a business, take out student loans, and build wealth.

Your credit can affect your access to things not even related to credit, such as utilities, cell phones, rental housing, and employment.

Justine PETERSEN

How Does a Credit Builder Loan Work?

When you take out a Credit Builder Loan, the borrowed funds are not distributed directly to you like they would with a traditional loan. Instead, they are deposited into a locked savings account. You will make monthly installment payments over a designated time frame (often 6-12 months). The monthly payments made toward the loan are reported to the credit bureaus. reported to the credit bureaus.  Consecutive, on-time payments are an important aspect for improving a credit profile which will reflect positively on your credit report and potentially raise your credit score. At the end of the installment payments, the funds are returned to you from the locked savings account.

Benefits and Risks

Credit Builder Loans are a low-risk way for you to improve your credit history and credit score. They are typically small-dollar loans that won’t involve hundreds of dollars paid in interest fees. Because your payments will be reported every month to the credit bureaus, you have the opportunity to show a positive payment history to future creditors and can increase your credit score. Did you know that your payment history accounts for as much as 35% of your FICO score? Those on-time payments can have a significant impact!

Another key benefit to a Credit Builder Loan is that at the end of your payments, you will have savings built up that will be returned to you. This allows you to continue to build on your savings habit and develop an emergency fund to help guard against a future financial setback. If you have the money to make your monthly payment towards the Credit Builder Loan, and you’ve been making that payment every month, why not continue to make that same payment into a savings account and keep building your savings? It can become a lifelong habit that continues to build your financial security!

It’s important to note though, that borrowers who make late payments on their credit builder loan may experience further damage to their credit scores. When you have a short credit history or a negative credit history, late payments can be significantly damaging, so you will want to make sure that the monthly payment you agree to is paid on time every month.

The Bottom Line

A credit builder loan isn’t the right choice for everyone, but it can be a tool for those who don’t have an established credit history or who have had credit challenges in their past.If you are experiencing financial difficulty and are looking for a solution, CESI is here to help. Our counselors are available to assist if you are experiencing job loss, temporary loss of income, or financial hardship during this time. Contact us today for a free financial assessment with one of our certified credit counselors.


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