“Get a credit card,” is the advice often given to those who want to start building credit – including on this site. But what if no bank will give you a credit card? Credit-builder loans may provide an off-the-beaten-path route to better credit.
What are credit-builder loans?
Credit-builder loans are a means to an end. While regular loans and non-secured credit cards can help you build credit, their primary purposes are convenience and paying for large purchases over time. Credit-builder loans, meanwhile, exist solely to build credit. You generally won’t find them with major banks, but some credit unions, nonprofits and small banks offer them (Consumer Action keeps a list here).
“The main differentiator between a credit-builder loan and a normal loan from a bank is that credit-builder loans are really set up for the intent of building credit for someone who doesn’t have it,” says Dara Duguay, executive director of Credit Builders Alliance, an organization that helps micro-lenders, small credit unions and other nonprofit lenders (some of which offer credit-building loans) report their clients’ payment histories to the credit bureaus.
In addition to helping those with no credit history, such loans can offer a leg up for people with damaged credit, says Michelle Dosher, managing editor for market research and consumer education for the Credit Union National Association.
“These types of loans could also be called credit ‘rebuilder’ loans, since they can help people who have fallen on hard times rebuild credit” Dosher says.
Recent research suggests that credit-builder loans from non-profit lenders keep those promises. A September 2014 analysis from Experian and Credit Builders Alliance found that, among those who used a credit product offered by a CBA member organization and paid as agreed, 58 percent were able to increase their VantageScores, and more than 20 percent moved to a lower credit risk category.
Types of credit-builder loans
Credit-builder loans vary, depending on the entity offering them, but these are some forms they may take:
1. A small unsecured loan: When offered by a credit union, this option involves lending a member a small amount of money — often less than $1,000 — and developing a plan for the member to show he or she can make timely payments over a set amount of time. This type of credit-building loan would most likely be an option for someone who already has an account with a credit union and may require a co-signer, Dosher says.
2. A small secured loan: You deposit a small amount of money up front to secure a loan of the same amount. You then pay the loan back, with each payment reported to the credit bureaus.
3. The “reverse” loan: There are two variations of this type. In some cases, you might make regular deposits toward a predetermined amount into a savings account. The lending institution reports these “payments” to the bureaus, and once the goal is reached, you get the money.
Or, the lender may place the loan amount into an account and “lock” it, preventing the borrower from accessing the funds until the final payment is made. Securityplus Federal Credit Union started offering this type of loan to its members at the beginning of 2013, says Mark Ely, the Baltimore credit union’s assistant vice president of marketing. Loan amounts range between $500 and $3,500, and terms range from six to 36 months. The average loan amount, according to Ely, is $1,600.
The program was developed, Ely says, for the kinds of members the credit union used to have to turn down. And it’s been more popular than expected.
“We expected, to be honest, not to be doing a lot of these,” Ely says. “But our employees have shown their passion for helping members by explaining this product. Now we can say, ‘You might not be able to get that car loan right now, but what we can offer is this.'”
Another surprise has been the way customers are using the loan. Although designed for credit-building it’s become a forced-savings vehicle for many, because the end result is money in a savings account. In fact, with the Securityplus FCU credit-builder loans, the amount “locked” in the account earns dividends while the member pays it off.
“It’s kind of funny how this has created a traditional savings vehicle for people,” Ely says. “Somebody knows they’re not going to habitually save and will just spend the money if it’s available to them right away. So this helps them train themselves to regularly put money in that account.”
Why not just get a secured card?
You may have noticed that credit-building loans require you to pay yourself back for a loan. So why not just get a secured credit card, which, in addition to credit building, offers the purchasing convenience of plastic?
Duguay says Credit Builders Alliance highly recommends secured cards, but they often don’t work as a first step for many of its members’ clients.
“One of the problems with secured cards is that when you’re talking about low-income people, it can be hard to just get that money for the deposit,” Duguay says. “So if you need to put down $300, $400, $500 dollars just to get the card, a lot of our clients don’t have it.”
Whichever form your credit-building loan takes, make sure of one thing: that the institution reports your payments to the credit bureaus.
“It can’t be a credit-building loan if they’re not building credit,” Duguay says. “There are many online lenders out there, for instance, that give small-dollar loans, but many of them don’t report the payment history to the credit bureaus.”
The flip side of getting a good payment history reported to the bureaus is the risk of having late payments reported if you slip up. However, just as credit card issuers often don’t report late payments until you’re one or two billing cycles late, credit-building loan providers often give clients some leniency as well, Duguay says.
“If someone’s having trouble making a payment on time, or they’re a couple days late, they usually have a good enough relationship [with the lender] that they can have a discussion with them,” Duguay says. “Plus, it’s normally not reported late if they’ve paid within that cycle. Let’s say someone was two days late. They might get a late fee, but it’s probably not going to be reported late until the second bill comes.”
Fees and costs
Credit-builder loans do come at a cost for the institutions that provide them, so expect some fees.
“[The lenders] obviously need to stay in business, but they’re certainly not trying to gouge their members,” Duguay says. “So they try to keep any fees to a reasonable amount.”
If you pay late, you might be charged a late fee. Some credit-builder loans charge application fees, or a fee to get your money at the end of the loan term. Innovative Changes (a member organization of the Credit Builders Alliance), for example, charges a $25 application fee at the beginning and a $25 processing fee at the end. Considering that the loan amount is for $150, that may seem steep — but those fees cover credit pulls throughout the life of the loan, and Innovative Changes also offers free one-on-one credit coaching, according to its website.
Others may charge interest – Securityplus FCU charges an annual percentage rate of 3.1 percent for its credit-building loan. That amounts to about $50 for a $1,600 loan with a one-year term, although the member keeps 0.1 percent each time they pay interest (via the dividends they earn on the money locked in the savings account).
“This product isn’t even close to a money-maker for us,” Ely says. “It’s not really about whether we’re making money but about helping people become more financially educated and financially independent from places like payday lenders.”
And that relationship-building concept, Dosher says, is why you’re probably more likely to find a credit-builder loan through a credit union than through other financial institutions.
“What the professionals at credit unions hope is that you’ll become a lifelong member so that they can provide other products and services that will help you throughout different life stages,” Dosher says. “Other financial institutions might not offer these opportunities.”
Even though credit-builder loans don’t pose much risk to the lender (because they often don’t give the borrower the money upfront), expect some underwriting.
“One of the reasons big banks don’t want to give these loans is that, for a $500 loan, there’s a lot of time and effort involved in servicing it,” Duguay says. “It’s not cost-effective. Even though our members aren’t in there to make profits like the banks are, they still don’t want defaults. So having some form of underwriting is really critical.”
At a big bank, loan underwriting would normally involve a credit pull. Yet organizations that offer credit-building loans often work with “credit invisibles” (such as recent immigrants), who don’t have any credit history. That means getting creative.
Member organizations of the Credit Builders Alliance, for example, may look at income and help the client fill out a budget (that includes living expenses) to see if regular monthly loan payments are realistic. Some even perform psychological tests, Duguay says, to determine if a potential client is reliable.
“They have quizzes people take,” Duguay says. “And based on their answers, they’ll either deny them or give them the loan. There are ways to underwrite a loan without a traditional credit history.”
Participation in financial education and credit-coaching might also be required to obtain a credit-building loan, Duguay says.
As for Securityplus FCU, the only underwriting requirement is agreeing to the loan terms. But chances are, the reason the member is being offered a credit-builder loan is that that he or she was rejected for another loan, based on a credit pull.
“We know they’re not credit worthy at that point,” Ely says. “The nice thing for us is that there’s really little risk [with credit-builder loans] “… If they choose to end the arrangement before they’re finished, we’ve collected the interest, so we’re not out anything but our employees’ time and resources.”