You’ve heard about credit builder loans and wonder if they could possibly work for you. It depends on what’s in your credit profile, but many have had success with credit builder loans. Before you sign up, it’s ideal to understand how they work and where you can find the best options for your financial situation. You should also understand the difference between unsecured and secured credit builder loans.
What is an Unsecured Loan?
An unsecured loan is a debt product that doesn’t require collateral to get approved. This means you won’t have to secure the loan with an asset like your car, home, or boat. And the lender can’t go after your assets if you default on a loan.
The lender focuses on your income, debt load, and credit history to make a lending decision. Expect to pay between 6 percent and 36 percent in interest, depending on your credit score. Some lenders also charge origination fees to cover loan processing costs.
When the loan is approved and finalized, you can use the proceeds however you’d like.
Quick note: You could be subject to prepayment penalties if you pay the loan off early.
What Is a Credit Builder Loan?
A credit builder loan caters to individuals who have poor credit and want to improve their credit health. Good or excellent credit isn’t needed to qualify, and you could get a loan even if you have little or no credit history.
If approved, you won’t get the loan proceeds right away. Instead, the funds will be placed in a savings account or Certificate of Deposit (CD), and you’ll make monthly payments for the duration of the loan term. When you make the final payment, the lender will release the funds to you (minus any applicable interest and fees).
Wondering if a credit builder loan is a good fit. It depends on your credit goals, but they offer several perks:
- Save money while building credit: When you pay the loan off, you can use the proceeds you receive to start or boost your emergency fund.
- No hard credit checks: You could get approved for a credit builder loan, even if you have little or no credit history. Consumers with bad credit could also be eligible for a loan.
- Low monthly payments: Depending on your selected product, you could choose your monthly payment to ensure it works for your budget.
- Reports to the credit bureaus: Timely payments mean good news for your payment history and overall credit health.
- Affordable one-time administrative fee: Most lenders charge administrative fees to open credit builder accounts, but they’re a small fraction of what you’d pay in loan origination fees for unsecured products.
- Competitive interest rates: You’ll pay interest on your credit builder loan, but it will likely be lower than the APR you’d have for an unsecured credit card because there’s less risk for the lender.
How a Credit Builder Loan Helps Build Credit
Lenders report payment activity for your credit builder loan to the three major credit bureaus to be added to credit reports – Experian, TransUnion, and Equifax. Payment history accounts for 35 percent of your credit score, so each timely payment helps build your credit history and could improve your score over time.
The Structure of Unsecured Credit Builder Loans
These loans can be a good option for borrowers with limited credit history or low credit scores. Here’s how they work.
Interest Rates and Terms
Most unsecured credit builder loans have term lengths that range from 6-24 months. A lengthier term will result in lower monthly payments but increase how much you pay in interest. Shorter terms have higher monthly payments but cost less money in the long run. Interest rates for these loans are typically higher than average.
Repayment Schedules
You will have to make fixed monthly payments until the end of the loan term. You can set the repayment schedule based on your chosen loan term. The term you choose will impact your annual percentage rate and monthly payments. It’s best to compare multiple term options to see which one fits within your budget.
Consequences of Default
Defaulting on an unsecured credit builder loan will hurt your credit score. The creditor can also give your debt to a collections agency.
Should You Get an Unsecured Credit Builder Loan?
Knowing the pros and cons of unsecured credit builder loans can help you decide if the financial product makes sense for you. These are some of the details to consider.
The Benefits of Unsecured Credit Builder Loans
Generally, you’ll find that most credit builder loans are secured by cash in a savings account or CD. However, there are unsecured credit builder loans that allow you to access loan proceeds right away.
You don’t need the best credit score to get an unsecured credit builder loan. These types of loans can also help you improve your credit score as long as you make on-time payments. Payment history makes up 35% of your credit score. Showing a good payment history on your credit report can help you secure lower interest rates on future personal loans and other financial products.
The Potential Risks and Drawbacks
The loans are enticing because they also allow you to build credit over time. However, they generally start with a small credit limit that could increase as you make timely payments. You will get a higher loan amount if you opt for a traditional loan.
Also, you forfeit the opportunity to save money while making monthly payments. When the loan is paid in full, there won’t be a pool of cash or CD for the bank or credit union to release to you.
Unsecured credit builder loans add another monthly payment to your expenses. It may not be a good idea for borrowers to take out these loans if they will have a difficult time paying them off. Late payments will have a negative impact on your credit score and can put you in a worse position than you were in before you took out the loan. You may also end up with a higher interest rate if you use an unsecured credit builder loan.
How to Apply for an Unsecured Credit Builder Loan
These are the steps you can take to apply for an unsecured credit builder loan.
Eligibility Requirements
Most of the best credit builder loans have few requirements. You don’t need good credit to get one of these loans. Many lenders don’t even require a hard credit check. They just want to make sure you have sufficient funds to cover the monthly payments. You will also have to provide basic information like your ID, Social Security Number, email address, home address, and other details. Each lender posts requirements on their website.
Essential Documents Needed
You will have to provide the following documents when applying for an unsecured credit builder loan:
- ID
- Proof of home address
- Social Security Number
- Bank account statements
- Employment information (i.e., pay stubs)
Application Process
Most lenders have a straightforward application process. You can fill out an online form, provide your information, and then hear back soon after. Some lenders offer same-day approval and let you access your funds quickly.
Is an Unsecured Credit Builder Loan Right For You?
Unsecured credit builder loans help people build credit even if they aren’t in good standing. The financial product’s viability doesn’t necessarily suggest that it’s the right choice for your finances. These are some of the details to consider.
Weighing the Pros and Cons
These loans are more accessible and have relatively low monthly payments. However, these loans are also more expensive in terms of fees and rates. For some people, these loans are the only viable option. However, borrowers who can secure better financial products that also aid in building their credit scores may want to consider those alternatives. It’s important to assess your financial situation and all of your choices before using this financial product.
Looking for Other Alternatives
Consumers can select from various alternatives to unsecured credit builder loans. People take out these loans to build their credit scores and access extra cash. Let’s consider some alternatives that accomplish one or both of those objectives very well:
- Secured credit builder loans: You can make a security deposit that acts as collateral for your credit builder loan. The bank will put this money into a CD so it grows over time. You will receive the security deposit back plus the CD funds after paying off the loan.
- Personal loans: These unsecured loans are better versions of unsecured credit builder loans. However, lenders have higher requirements for these loans and often require hard credit checks.
- Becoming an authorized user: You won’t get extra capital this way, but becoming an authorized user for someone else’s credit card can improve your score. Authorized users get the same payment history as the cardholder. If you are an authorized user of someone who pays bills on time, your credit score will go up.
- Secured credit builder cards: You will have to put up a security deposit for this card, but it’s a better choice if you can get through that hurdle. You will build credit with on-time payments. If you pay off your bill at the end of each month, you won’t even have to worry about interest or fees. Most secured credit cards do not have credit score requirements, and the providers do not run hard credit checks.
