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To grow credit, you must first obtain credit, which can be a stressful undertaking for individuals just starting out or attempting to add a variety of credit kinds to their financial portfolio. Lenders are less likely to approve someone with a low credit score or a thin credit file. If you find yourself in this situation, a credit-building loan may be worth considering.

A credit-builder loan is intended to help people with little or no credit history establish credit. That’s why credit-building loans are often known as “Fresh Start Loans” or “Starting Over Loans.” Growing your credit score has numerous benefits, including increased likelihood of approval for credit cards and loans at better rates.

Credit-builder loans do not require good credit to be approved. However, they do need that you have a sufficient income to make payments. When applying, you may be asked to supply information about your employment history, income, and checking or savings account balances.

How Does a Credit Builder Loan Work?

In a traditional loan, the borrower receives the money first and repays it over time. With a credit-builder loan, the lender holds the entire loan amount while the applicant makes payments. After all installments are made, the borrower receives the entire loan amount. Holding the money in a secured account until the loan is fully repaid provides a safety net for the lender taking on risk if you have no credit experience or low credit scores.

During the loan term, your timely payments are reported to at least one major credit agency, but if possible, look for loans that report to all three (Equifax, Experian, and TransUnion). Because FICO and VantageScore base their scores mostly on your payment history, it is critical that you make your payments on schedule. Having your on-time payments reported helps you develop credit and demonstrates your ability to manage a credit account.

Another perk of a credit-building loan? At the end of the loan’s terms, you’ll have a cash reserve that can be used as an emergency fund or for another key savings purpose.

There are two groups of people who might want to consider a credit-builder loan:

Those who are credit-invisible

Credit-builder loans can help people who are “credit invisible” — they don’t have a credit score or report — get on the scoring radar and can be a good choice for credit newbies. Some 28 million Americans fall into this category, according to a 2022 report by Experian and management consultating firm Oliver Wyman.

While people who are credit-invisible can use debit cards or cash, they have limited access to financial products and services, which can pose real obstacles as they try to purchase a car or home or get approved for a credit card or apartment lease.

Those with a thin credit file

There are 21 million Americans who are considered “unscoreable” because their limited credit file does not include enough information to produce a credit score, according to the Experian and Oliver Wyman report. A credit-builder loan can help people with a thin credit file by adding another account type to their portfolio.

While not the most important factor, credit mix is used to calculate credit scores. Having a credit history with different kinds of accounts can build your scores, and if you have a record of on-time payments with your other credit this could be a low-risk way to simultaneously grow your score and reach a savings goal.

Benefits and Risks of Credit-builder Loans

When applying for financial products and services, your credit score is the most important factor in determining the rates you will be charged. If that number is insufficient, you may be saddled with exorbitant interest rates and high monthly payments.

Read Also: Understanding Credit Card Rewards and Cash back

Credit-builder loans are one option for addressing this issue. While these are expressly created for debtors looking to improve their ratings, the strategy is not without risk. Before applying for a credit-building loan, consider the advantages and disadvantages.

Benefits of credit-builder loans

A credit-builder loan is a means to demonstrate to the main credit bureaus that you can consistently make timely payments. This will make it easier for you to get more financial products in the future. Consider the major advantages of choosing one of these sorts of loans.

  • Flexible acceptance

Because the market for credit-builder loans is designed for those with low credit scores and little or no credit history, lenders have much more flexible requirements. Lenders will not require good credit but instead will request information on your income, employment history and balances for your savings and checking accounts.

  • Can improve your credit

Most notably, credit-builder loans can improve your credit score. As you pay each month those on-time payments are reported to credit bureaus. Payment history accounts for 35 percent of your score, and as that improves your credit score will follow.

  • Ability to build savings

Typically when you take out a loan you are borrowing money to pay for a significant expense — but in this case the lender holds onto the money then returns to you once you’ve paid it off, minus any fees. With restricted access until it is paid in full you can effectively build extra savings.

Risks of credit-builder loans

Although credit-builder loans can carry many upsides, there are still risks associated with taking out a financial product. Take a moment to consider the drawbacks to this option before heading into the application process.

  • Potential to drop credit score

As with adding any loan to your rolodex a credit-builder loan has the potential to lower your credit score if you miss payments. Missing payments on a credit-builder loan can dramatically decrease your score and potentially put you in a more challenging financial spot.

  • Lenders can charge high fees

Like interest rates, standard fees vary significantly across different lenders. Some offer zero fees while others enforce steep fees that can shift your expected monthly or overall cost by a significant amount. Common fees included prepayment penalties, application or administrative fees, and processing fees.

  • No immediate access to money

Credit-builder loans tend to carry repayment terms of up to 24 months, and access to the loan is not granted until after the payoff. These loans are not great for those who require fast access to cash, as you must fully repay the loan to get the money.

Do Loans Build Credit Faster Than Credit Cards?

Your credit score shows how effectively you’ve handled borrowed money, and lenders use it to assess how risky it is to give you money. Handle a loan responsibly, and your credit score should improve. However, not every loan affects your credit score in the same way. In fact, the loans with the highest risk of getting you in trouble also have the highest chance of improving your credit score.

There are many types of loans, but for this discussion we’ll focus on two broad categories.

  • Installment loans such as mortgages, car loans, student loans and personal loans. With an installment loan, the lender decides how much you can borrow and how much you need to pay back each month. You generally can’t borrow additional money on the same loan, and you have little flexibility in payments.
  • Revolving loans like credit cards and home equity lines of credit. With revolving loans, the lender decides on the size of your credit line, but you decide how much of it you will use. You choose how much to borrow, when to borrow it and how much to repay at any given time — as long as you make a minimum payment each month. You can borrow money on the credit line, pay it off and borrow again as many times as you want.

When lenders examine your credit history and credit score, they attempt to anticipate how well you will handle new credit if it is extended to you. Installment loans demonstrate that you have already been deemed creditworthy by another lender and that you can make timely payments. That surely helps to build your credit history.

Revolving accounts, such as credit cards, offer considerably more information. Credit cards allow you to borrow, repay, and borrow again, demonstrating your credit-handling skills more successfully. This makes them a better predictor of how you will use credit in the future, according to Rod Griffin, Experian’s head of public education.

“You’re exercising free will,” Griffin explains when you use a credit card. “It gives a little more weight to scores because it’s more predictive of how you make individual credit decisions.”

The downside of employing revolving loans is that their interest rates are typically greater than installment loans. If your balance becomes too large, it can be difficult to pay off the debt because more of your monthly payment is going toward interest rather than reducing what you owe. Using a credit card responsibly and staying within your means demonstrates to lenders that you can be trusted with additional loans.

There is no regulation that states you must have a credit card to have good credit, and you are not required to carry a debt on a credit card once you have one. However, a revolving account can help future lenders view your full potential as a borrower.

Griffin explains a simple technique for building credit with a credit card.

“If you can get a credit card — maybe two — make a small purchase and pay it off each month. It will help you build your credit history and establish credit more quickly,” he explains.

There is no regulation that states you must have a credit card to have good credit, and you are not required to carry a debt on a credit card once you have one. However, a revolving account can help future lenders view your full potential as a borrower.

Griffin explains a simple technique for building credit with a credit card.

“If you can get a credit card — maybe two — make a small purchase and pay it off each month. It will help you build your credit history and establish credit more quickly,” he explains.

Many people find it easier to apply for a credit card than to actually receive one. If you have bad or no credit, a decent place to start is with a secured credit card that needs a security deposit. However, simply receiving the card and putting it in your wallet is insufficient. To properly demonstrate to lenders that you are competent of managing flexible credit accounts, you must utilize them on a regular basis and make timely payments.

“It’s not that you can’t have great credit scores with just installment loans,” Griffin clarifies. “It’s just that a credit card … gets you there a little bit faster.”

What Loans Help Build Credit?

Building credit can be a lengthy process, so it’s natural to look for ways to speed it up. One issue you may have is if the types of loans you use are important when creating credit.

While the sort of loans you have may have an impact on your credit score, it is far less essential than how you handle your credit accounts. Continue reading to find out how loans affect credit, which ones can help you establish credit, and what factors are most important in attaining a high credit score.

You can use a variety of loans to boost your credit. You can utilize a revolving credit line, like a credit card, or installment loans, such as auto loans, home loans, school loans, personal loans, credit-builder loans, and others.

But do some loans do a better job of building credit than others? It can depend on a few factors. If a lender reports your loan payments to all three credit bureaus (Experian, TransUnion and Equifax)—and you make all your payments on time—this can help your credit scores across the board.

But because lenders don’t always do that, you could have a loan that is helping your credit score based on the information in one of your credit reports but is doing nothing for a score based on a different report. This doesn’t depend on the type of loan but rather on the lender itself. Additionally, certain types of loans, such as payday loans and pawn loans, typically don’t report payments and thus won’t do anything to help your credit.

The bigger consideration is whether you can qualify for loans that can help you build credit. Some loans may be more accessible than others if you have a limited credit history or your credit score is low.

For example, you may have a hard time getting a mortgage loan or an affordable auto or personal loan if you’ve had credit problems in the past or have a thin credit file with few or no accounts. But if you’re a college student, you don’t need a credit history to obtain federal student loans—and your student loan can help you build credit as well as any other type of installment loan. Additionally, there are secured credit cards and credit-builder loans that are designed specifically to help those with little credit establish a positive credit history.

It’s important, however, to note the difference in how credit cards and installment loans work.

With a credit card, your credit utilization rate—the percentage of your credit limit that you’re using at a given time—is an important factor in your FICO® Score , which is the score used by 90% of top lenders.

Utilization rate doesn’t come into play with installment loans, but FICO does consider how much you owe on this type of loan. Still, playing down a large chunk of credit card debt could have a more significant positive impact on your credit score than making a large payment on an installment loan.

If you don’t have a high utilization rate to begin with, there isn’t a huge difference between the two types of credit in terms of how they can help improve your credit score.

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