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How Credit Builder Loans Work

I'm not a big advocate of credit builder loans because they essentially promote taking on debt for the sole purpose of building credit, and I don't think that's a very smart way to approach the credit-scoring game. However, credit builder loans might be a decent option for those who feel like their back is up against the wall because they've run out of traditional ways to build credit. If this includes you, here's a brief explanation of how credit builder loans work and why you might find them useful on your credit-building journey.

What is a Credit Builder Loan?

Credit builder loans typically come in two forms and are offered by credit unions or small community banks. In some cases, the borrower makes a deposit with the lender who places the money in an interest-bearing account and provides a line of credit to the borrower for the same amount. The borrower then makes monthly payments, which are reported to the major credit bureaus until the loan is paid off in full. In other cases, the lender will actually place the amount that is loaned directly into an interest-bearing savings account.

The borrower then makes monthly payments on the loan even though they have never touched the money. Once the loan is paid off in full, the borrower will receive access to the funds. Try thinking about these loans like this. The interest rate charged will most certainly be higher than what the borrower earns in the interest-bearing account. Therefore, the borrower is basically paying a fee (the difference between what is earned and paid in interest) in order to have some positive payment history reported to the credit bureaus. While it may sound a bit shady, it does work as long as your payments are made on-time and correctly reported to the major credit reporting agencies.

How Credit Builder Loans Improve Credit Scores

Payment history accounts for 35% of your FICO credit scores. As long as your on-time payments via a credit builder loan are reported to the major credit bureaus, your credit scores will benefit. It's that simple. In fact, there's nothing else that can have a more positive effect on your overall credit scores than improving your payment history.

The Final Word

Exhaust all your other credit-building options first. Try piggybacking on a relative's good credit or using secured credit cards instead. Both of these methods can help achieve the same results without taking on any debt or paying unnecessary interest charges. If all else fails, then look to a local credit union that offers credit builder loans with low interest rates and a guarantee that your payments will be reported to the major credit bureaus. Photo by MoneyBlogNewz

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Joshua Heckathorn's picture

Joshua Heckathorn is a credit expert and has been featured on CNNMoney, FOX Business, Yahoo Finance, The Street, and many other national publications during the past twenty years.  He received a Bachelor of Science in Management (Finance) from Brigham Young University's Marriott School of Business and earned his MBA from Seattle University.

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