About one in ten adults in the United States have no credit record. An additional 19 million Americans have a credit histor too brief or out of date to have a credit score.
Building a positive credit history is important if you want to buy a home, car, rent an apartment or start a business. It’s also important to qualify for other financing opportunities, such as personal loans and credit cards.
A credit-builder account is one tool consumers can use to establish or improve credit.
Table of Contents
- 1 What Is a Credit Builder Account?
- 2 What Are the Pros of Credit Builder Accounts?
- 3 What Are the Cons of Credit Builder Accounts?
- 4 Should You Open a Credit Builder Account?
What Is a Credit Builder Account?
A CBA is a financial product intended to help people with limited, poor, or no credit history build or improve credit. The two main types of CBAs are credit builder loans and secured credit cards.
What Is a Credit Builder Loan?
Credit builder loans work similarly to personal loans. However borrowers must make payments before the lender provides them with the requested funds. When a borrower opens a credit builder loan, the lender places funds in a locked savings account. The borrower must make installment payments according to the lending agreement.
Credit building loans are usually for $300 to $1,000, and the repayment period is usually six to 24 months.
The lender reports whether the borrower made payments on time or not to credit reporting agencies and deposits the principal payments into the borrower’s savings account either when the borrower makes a payment or at the conclusion of the program. Sometimes credit builder loans are offered as part of a credit building program.
What Is a Secured Credit Card?
A secured credit card is a credit card that requires the cardholder to make a security deposit to open the account. The security deposit is usually equal to the credit limit for the card. Credit card companies offer these cards to consumers with limited or poor credit history because the security deposit reduces the risk to the creditor.
If the customer does not make payments on time, the creditor can use the security deposit to cover the late or missed payment.
What Are the Pros of Credit Builder Accounts?
A Credit builder account can be an effective tool for some consumers to build or repair their credit.
Can Help Establish a Credit Score
Many lenders are hesitant to provide credit to borrowers who have little or no credit history. Opening a secured credit card or taking out a credit builder loan may help establish a credit score.
May Improve Your Credit Score
The main selling point of these accounts is that the customer’s payments are reported to the three major credit bureaus. Customers who make on-time payments may experience an increase in their credit scores by using these accounts.
However, research has suggested that customers who have no existing debt are more likely to experience an increase than other customers.
May Help You Build Savings
Credit builder loans are marketed as a tool to build savings because the principal payments customers make on these loans are deposited into a savings account. Research has indicated that many customers do build a significant savings balance; however, it is unclear whether most customers continue to maintain the savings balance when the program is over.
Less Financial Risk Than Other Types of Credit
Because your credit limit is usually equal to the amount of your security deposit on a secured credit card, and you do not receive any funds from a credit builder loan until you make payments, there is little risk of accumulating a long-term outstanding balance with either product.
Lower Interest Rates
Borrowers with limited or poor credit usually pay higher rates for financing because of the perceived risk that they will not repay their debts. Improving your credit score by using a credit-builder account may enable you to obtain traditional financing at lower interest rates.
What Are the Cons of Credit Builder Accounts?
CBAs also have risks and costs that consumers should consider before opening an account.
Limited Independent Research
While creditors tout their products as a means to build credit, there is little independent research to support their claims.
Your Credit Score Could Go Down
Reporting your payments to the credit bureaus is a double-edged sword. While on-time payments could improve your score, late payments and closed accounts could cause your score to go down.
Ties Up Funds You Could Use for Other Things
The money you use to put down a security deposit on a secured credit card or to make payments on a credit builder loan could be used to pay other bills, including any outstanding debt you have. Research has shown that borrowers with existing debt may have difficulty incorporating a credit-builder account with their regular debt, leading to missed payments on both types of debt.
Additionally, using the money to pay down existing debt may improve your score more than making payments on a credit building account.
Interest Charges and Fees
You must pay interest on a credit-building loan. Secured credit cards often come with the application, late, annual, processing, and other fees. Additionally, if you don’t pay your entire balance every month, you pay interest on your balance.
Should You Open a Credit Builder Account?
Research suggests that most people who have existing debt should focus on paying down that debt or utilizing other credit building programs, such as credit education, money management courses, credit counseling, or financial counseling. The potential benefits of opening a credit-builder account are small and may not outweigh the risk of missing payments for this group.
If you have no existing debt and you need to establish credit, a credit building account may be beneficial if you make your payments on time. However, it is important to ensure that the company reports to the major credit bureaus and to investigate the total cost of the interest and fees you must pay to have the account.
The financial experts at Fiscal Tiger can help you learn more about the best ways to build credit. Visit us online for more information.
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