Credit Builder Loans Can Help Burnish Your Credit Score

     If you’re one of the many people whose credit took a big hit during the Great Recession, you may be looking for ways to nurse your score back to health. And we’ve written about a variety of strategies and products, including secured credit cards, that can help you along.

But I recently stumbled upon another credit-building product, conveniently known as a credit builder loan, that helps consumers establish credit or improve their scores.

“Credit builder loans are offered as a way for credit union members to do a couple of things: get something good on their credit reports and set aside some money for future use,”  said the credit scoring guru John Ulzheimer.

     The loans, which are usually for small amounts, generally work in a couple of ways. A typical credit builder loan acts much like a layaway plan: instead of getting the money upfront, the borrower makes payments on the loan over a period of time, perhaps a year, and the credit union puts the money in an interest-bearing savings account. Once the loan is paid off, the borrower gets access to the money.

In other cases, the borrower may give, say, $300 or $500 to the lender upfront, who then puts the money in an interest-bearing savings account as collateral. Then, the lender provides a line of credit up to that amount, which the borrower pays off in monthly installments, said Vikki Frank, executive director of the Credit Builders Alliance, which helps microfinance and other nonprofit lenders report the consumers’ payment histories to the big credit bureaus.

(As you may imagine, borrowers usually pay more in interest on the loan than what they earn on their savings. The rates on the loans can range anywhere from the single digits up to 18 percent, though some credit unions subsidize the rates and charge 3 to 5 percent, Ms. Frank added. And some other nonprofits don’t charge any interest at all.)

       With both types of loans, the lender reports the borrower’s payments to the big credit reporting agencies; of course, late or missed payments are also reported.  Ms. Frank said that her organization currently helps small lenders report to TransUnion and Experian. (On their own, individual lenders may not otherwise be able to meet the bureaus’ threshold for reporting a minimum amount of loans. That’s why the alliance is currently unable to report to Equifax, which has not agreed to waive its reporting minimums. Equifax could not immediately be reached for comment.)

“Getting two out of three is critically important because mortgages are generally based on the mid-score of all three bureaus,” Ms. Frank said, adding that if the consumer has no score at one credit bureau, the lower of their other two scores would be the mid-score.

So before you agree to take out one of these loans, just be sure that they are indeed reporting to at least some of the big bureaus. After all, the bureaus are the ones that provide the reports that are used to create the FICO score, which most lenders use to judge borrowers.

Nearly 15 percent of the 7,400 credit unions in the United States offer a credit builder program, according to Steven Rick, a senior economist at Credit Union National Association. You can see if you’re eligible to join a credit union through the aSmarterChoice.org Web site, though you’ll have to call or go to credit union’s individual sites to see if it offers these loans. The loans may also be offered at certain community banks, as well as at certified community development financial institutions, which cater to low- and moderate-income households.

If you can’t find a credit union that you are eligible to join, you can always consider using a secured card, where you are required to put a certain amount of money into a bank account, say $250 or $500, which is then used as collateral. And the available amount of credit is often equivalent to the amount on deposit.

One of the differences between a credit builder loan and a secured card is that you immediately have access to money on the secured card, which isn’t necessarily true with a credit builder loan. And the interest on the secured card is probably going to be much higher than the credit builder loan’s rates, Mr. Ulzheimer said.

“I’m kind of neutral on these loans because they act as an incentive to incur debt simply to rebuild credit,” he added. “That fuels the fire of people who hate credit scoring and say they are an incentive to get into debt.”

But for those who want to eventually secure a decent rate on a car loan or a mortgage, credit builder loans may be a solid stepping stone.

“The credit builder loan is about giving people an opportunity to start building relationships with some sort of financial institution that will help them build a credit history, and will hopefully help them build financial relationships and become part of the mainstream,” Ms. Frank said