Did You Know you can use credit builder loans to establish credit?
When the topic of establishing credit comes up, it seems like the conversation inevitably defaults to the same three strategies:
- Have someone else cosign a loan with you.
- Have someone add you as an authorized user on his or her credit card.
- Open a secured credit card in your name.
These strategies all have their uses, but it’s interesting how seldom you hear about another strategy – one that was actually designed specifically for building credit. Its name, appropriately enough, is the credit builder loan.
A credit builder loan is a type of loan, intentionally structured as a “Credit 101” loan, that is normally extended by credit unions. The loans vary in amount but are normally very small. In fact, they rarely exceed $1,000. The amortization period, or the amount of time you have to pay it back, is similarly small, generally not more than 12 months. Monthly payments are very low, less than $100 in most cases, and you’re out from under the debt in less than a year.
What’s unique about credit builder loans is you don’t receive the loan amount upon approval of the loan. Instead, the credit union keeps the money for you. Think of it as a layaway plan: If you take out a $1,000 loan, that $1,000 goes into an interest-bearing account rather than your pocket. If you default, the credit union has that money as protection. But if you complete your payments, when you’re done, you’ll have the loan amount, plus interest, as savings. (Often, the interest rate you pay on the loan is higher than the rate you earn on the loan amount, but credit unions and other nonprofits vary, so check those rates in advance.)
Great! So these loans can help you save, but they’re not called “savings builder loans.” So how does the credit building happen?
As you make your monthly payments, the credit union reports your payback activity to the three national credit reporting companies (CRCs) – Equifax, Experian and TransUnion. A steady series of on-time payments means you:
- Establish credit reports if you don’t have any
- Rebuild or improve your credit file if it’s in need of improvement; and even perhaps
- Increase your credit scores.
Of course, if you miss payments on the loan, then this credit reporting can backfire and cause lower scores.
After you’ve finished paying off the credit builder loan, the credit union will release the funds to you plus any interest you earned. You can use the money for whatever you like, although the smart choice would be to pay off other debt, establish an emergency fund, or stick the money in an IRA or Certificate of Deposit. And the best news of all, the positive history of the loan will remain on your credit reports for many years to come.