Dear Creditnet: My credit scores are in bad shape and I've been researching ways to start rebuilding my credit so I can eventually get an auto loan at a decent interest rate. It turns out that the credit union I use offers a "credit builder loan" that is supposed to help my credit scores. How does a credit builder loan work, and will it actually improve my FICO scores? It kind of seems like a scam to me because the interest rate is pretty high, but I've used this credit union for a long time and have always been happy with their products and customer service. - Justin T. from MA
Answer: While I don't know exactly where you bank, here's how credit builder loans work at most credit unions. You request a loan amount of something like $1,000. Your credit union will then place those funds in a savings account where it will earn a small amount of interest. You will then repay the loan balance plus interest over a term of 6-12 months.
As you make the payments your credit union will report the payment history to the major credit bureaus, which in turn will help improve your FICO scores as long as you continue to make all your payments on time. Once the loan is repaid, you will then be able to withdrawal the funds from the savings account as you please, so the loan acts as a tool to promote saving as well.
Are these credit builder loans a scam? Well, not really, but the main concern is that the amount of interest you earn on the savings account will most certainly be less than the interest rate charged on the loan. That means you're basically paying the credit union for the opportunity to take on debt and build credit, and this doesn't sit well with a lot of people in your position. Your credit union will most likely offer a secured credit card product as well, which can provide the same benefits for your credit scores (without paying interest) while also giving you immediate access to the cash you deposit as collateral. Interest rates for secured cards will be high too, but you won't need to worry about paying any interest as long as you can commit to always making your monthly payments on time and in full.
You don't get the option to avoid unnecessary interest charges with a credit builder loan, which is why I suggest first looking into using a secured credit card with a low annual fee to begin rebuilding your credit. If your credit union doesn't offer one, the Capital One Secured MasterCard is a good option worth checking out. It only has a $29 annual fee, offers a credit line of up to $3,000, and is arguably the best secured credit card on the market right now. Photo by Steven Depolo