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Applying for credit for the first time is a bit like applying for your first job. People are hesitant to hire you because you don't have any job experience, and you can't get any job experience because nobody will hire you. In the case of credit applications, creditors are leery of extending credit if they don't have any evidence that you will pay your bills on time.

Credit-builder loans are designed to help those with little or no credit history to build their credit. Loan amounts are relatively small (typically between $500 - $1500) to minimize the lender's risk. The lender reports your activity to the credit bureaus, thus establishing your credit history.

There are three basic types of credit-builder loan:

  • Standard Secured – The amount of your loan is backed by money that you already have in a savings account. That collateral is frozen, and the funds are released to you in increments as the loan is paid down. Your collateral decreases the risk to the lender, generally producing a lower interest rate.
  • Secured by Funds – If you just want to build credit but don't have an immediate need for the money, this type of pure credit-builder loan may be for you. It's essentially a forced savings account. The bank puts the loan amount aside in a locked savings account, and once you make all the payments, you receive the funds. Think of it as making regular contributions to a nest egg while building credit in the process.
  • Unsecured – This is more like a traditional loan, or even a credit card. The bank will loan you money up front, but at a higher interest rate to minimize risk. The lender may be more stringent with requirements or limit the loan amount.

Credit-builder loans are excellent for teaching your children responsible use of credit. Adam Carroll, Chief Education Officer at National Financial Educators explains, "Parents can take their children to a credit union and sign them up for a credit builder loan that might be $500, but the payment is made every single month.... Let's say the loan is for a lawnmower that the kid's going to start a business with. That's a great way to start building credit for your student." Using that method, you can directly tie the loan into an income source.

Credit-builder loans are available through banks, credit unions, and some non-profit organizations, such as economic development groups. Consumer Action provides a partial directory of sources for credit-builder loans by state.

Not all lenders offer credit-builder loans. You may have better luck at credit unions that are effectively owned by depositors and have a slightly different emphasis than banks. In Carroll's words: "Credit unions generally have a mentality of people helping people. And as a result, they're offering products and services that a bank may not offer."

Credit unions are targeted to a membership, but that membership category is often very broad. Check the requirements of the credit unions in your area, but don't forget your local bank. They may be equally willing to work with you.

Credit-builder loans do carry one big risk: You can establish a bad credit history instead of a good one. It's extremely important to make all payments on time. A credit-builder loan is your first impression to the credit market, and if your impression is that prompt repayment isn't a priority for you, it will be even more difficult to build your credit from here on out. A fully secured credit card might be your best option at that point.

Used wisely, credit-builder loans can help you build a good credit score in a relatively short time. Before taking out such a loan, make sure that you are in a suitable financial position to make your payments. You need sufficient regular income to make the payments. If you already have trouble paying your existing bills, a credit-builder loan is not going to help.

Once you have verified that you can handle the obligations, search available credit unions and banks in your area for the best deal for your situation. Read over all the terms and conditions to make sure you understand the interest rate and total loan costs, timing of payments, and all obligations.

Above all, make sure that the lender does report your loan activity to the credit bureaus. That's the main reason to take out a credit-builder loan in the first place.

You can check your credit score and read your credit report for free within minutes using Credit Manager by MoneyTips.


Photo ©iStockphoto.com/c-George

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