When you don’t have a credit history or your credit score is low, popular wisdom says to get a loan. With a new loan, you should be able to make payments and improve your score over time, right? Unfortunately, you can’t always just ‘get a loan’ in the real world, and this is especially true if your credit is nonexistent or really bad.
Secured credit cards have long been a good solution for consumers who need to improve their credit but cannot get approved for a loan. With a secured credit card, you put down a cash deposit as security and have access to a line of credit against which you can borrow. Your credit card payments are reported to all three credit bureaus, giving you the opportunity to improve your credit score over time.
Interestingly, another type of bad credit loan product has entered the market over the past decade. Credit institution loans work the same way as secured credit cards in that they allow consumers to secure their own loan and make monthly payments that are reported to the credit bureaus. But, do credit builder loans really help?
A closer look at credit construction loans
According to Michael Broughton, CEO and founder of Perch credit, which helps consumers build credit using their rent payments, credit construction loans can absolutely help consumers improve their credit rating.
Take the credit builder loans or “credit savings accounts” of Self, for example. With Self, you apply for a credit builder account, accept monthly payments, and eventually pay whatever amount you agree to. Plus, you get all the money you paid back at the end, minus the fees.
“These types of loans help build your credit because the lender will report each of your successful payments to the three major credit bureaus,” says Broughton. “Since the biggest impact on your credit score is payment history, over time the payments you make on these credit loans will increase your credit score. “
A credit builder loan can also be a great way to start your credit journey if you have little or no other credit history, he says.
Adem Selita, CEO and co-founder of The Debt Relief Company Said the good thing about credit builder loans is that you can apply for a very low balance credit builder loan with low monthly payments. Since Self accounts come with monthly payments as low as $ 25, that means most people can afford to build credit this way.
From there, the payments on a credit builder loan offset the negative impact of any missed or late payments you have had in the past. Also, paying off the credit builder loan completely on time will provide one more case in which you demonstrate financial responsibility, which shows that you are a good credit risk.
Even the Consumer Financial Protection Bureau (CFPB) agrees that credit loans can be a boon to consumers who need to obtain credit. According to a CFPB Report, those who applied without an existing loan increased their likelihood of getting a good credit score by 24%. Not only that, but participants who took out a credit loan without any existing debt saw their credit score increase by 60 points more than participants who had a history of credit and debt.
Plus, credit builder loans work like a forced savings account. Based on this fact, users profiled by the CFPB reported increasing their savings balance by an average of $ 253.
Credit loans: what to watch out for?
For the most part, the loans from the credit builders are quite straightforward. You agree to pay a specific amount each month, and the company providing the “loan” records that money for you in an account. They report each of your monthly payments to the credit bureaus, and over time your score goes up. Ultimately, you are rewarded with the money you put into the account during the life of the loan.
So what’s the catch?
Broughton points out that while a credit loan can actually create credit over time, it does cost the borrower something. Take Self Credit Loans, for example. This supplier is very transparent about the costs involved in their product, but their numbers still show that nothing is free.
With Self, you can agree to pay $ 48 per month and an upfront fee of $ 9 to open your account. From there, you would pay $ 48 per month for 12 months. Once this year is over, you will receive $ 539 back, or $ 46 less that you paid.
Another company in this space, Strong Credit, offers a similar pricing structure. In their sample website, you pay an upfront administrative fee of $ 8.95 to open your account. From there, between 88% and 98% of your payment is applied to your account each month, with the rest going to fees.
It’s not a lot of money to waste on building your credit, but it’s still worth noting.
Another problem with the credit builders loans is the fact that they may not work in your favor if you are going through a difficult time. If you make late payments on your credit loan, these are also reported to the credit bureaus.
This means that instead of your on-time payments improving your credit score, late mortgage payments can actually worsen your credit score. And if you started your credit institution loan because you had no credit history, you are sure to start your credit journey on the wrong foot.
This is why credit loans should only be used by people who take their credit goals seriously and are ready to make a commitment. James Garvey, CEO and co-founder of Self, says loan products like Self’s can be a great entry-level tool for someone who wants to build credit from scratch or after financial difficulties. After all, you have the chance to build positive credit habits while pursuing goals like buying a home or pay for college.
“However, like any tool, for credit builder loans to help you, you have to use them responsibly,” he says.