Written by Anne-Marie Hays | Last Updated October 31st, 2019Anne-Marie Hays is a Content Management Intern with Best Company. She enjoys comedy, hates crowds, and loves that you are reading this bio.
For underbanked Americans who can't get approved for mainstream credit, it can be hard to find opportunities to build credit.
Credit builder loans
We asked Zara Mohidin, Head of Strategy and Business Development at Fig Loans, what advice she has for people at the start of their financial journey, seeking credit for the first time. Here's what she had to say:
"The first place I would start is with a credit builder loan! It's a super easy, risk-free way to start building credit.
What is a credit builder loan? It's a reverse loan, meaning that you make payments into a savings account over the course of one year. Then, at the end of the year, you'll receive all the principal you paid in and your credit score will be improved!"
Did you know that credit builder loans are one of the three ways that the Consumer Financial Protection Bureau suggests establishing first-time credit?
This type of loan is meant for people with no credit or bad credit. Basically, it helps to establish some positive payment history, which is the biggest factor affecting your credit score.
A credit builder is a secured loan. You make payments into an account—often one that accrues interest. Then, once you have completed the loan, you get the money back, and you have an established, positive credit record.
You've basically proven that you can handle money wisely and make on-time payments. Next, you can apply for other types of loans, including unsecured credit cards or personal loans, with a better chance of getting accepted.
Credit builder loans vs. secured credit cards
The CFPB's second suggestion for establishing credit is with a secured credit card, when you don't have enough or sufficient credit history to get an unsecured credit card. A secured credit card is similar to a credit builder loan. The difference is that the consumer puts a deposit into an account up-front. That amount makes up your credit limit, accessible on your card. From there, you can build up your history of positive on-time payments.
When it comes to choosing between the two options, you might want to consider your spending habits. Often, credit cards make it easier to feel less inhibited about spending. You will have to be extra careful not to spend more than you can pay off in a month, so that you do incur too much in the way of interest charges for outstanding monthly balances.
Remember, that while you may also be required to pay interest on a credit builder loan, you will also earn interest on the CD or savings account where your money is being held. Credit Builder loans are likely the safer option in the long-run.
Credit builder loans vs. retail credit cards
The CFPB's third suggestion for establishing credit from scratch is with a retail credit card. Nathan Grant, a Credit Industry Analyst from Credit Card Insider helps us compare and contrast these two products and their credit building potential. Grant explains, "Both a retail store credit card and a credit builder loan are using essentially the same methods to help individuals build up their credit scores — making on-time payments month-to-month until your balances are paid down to show that you are a responsible borrower."
However, just like secured cards, there are differences. Grant points out that "Credit builder loans are installment loans while retail store credit cards are, like any other credit card, a revolving balance, and having a good mix of types of credit can also contribute positively to your credit scores.
With a credit builder loan, you're guaranteed to pay some interest, while you can avoid interest charges by paying off your statement balance in full on a retail credit card. That said, if you fail to pay off your retail card balance by the due date, you'll be stuck earning interest at what's likely a much higher rate than with a credit builder loan."
So again, the CBL is the safer option if you aren't confident in your monthly budgeting skills, says Grant. However, you need to think about startup costs and ease of access: "A credit builder loan is generally easier to get with no credit, but you have to pay up front, while a retail card won't cost you anything up front but may be a bit harder to get with no credit."
"Since everyone's financial situation is completely unique outside of just credit scores," Grant explains, "there is no blanket recommendation that would be the go-to choice every time. Your best bet is to self-assess your responsibility and your financial objectives beyond just building credit and see what option makes the most sense for you." Sometimes a mix of different credit building products can lead to the best results, especially if you are financially responsible with them.
Shop around to see what is available in your area, or at your local credit union. "It's important to remember that not all credit builders are the same," says Mohidin. "Some credit builder loans actually penalize you for being late by charging late fees and reporting your payment as delinquent to the credit bureaus." That can be a "two steps forward, one-step-back" type of move, where you will lose out on many of the benefits.
Fig's credit builder loan doesn't penalize you for late payments. Instead, an account is closed, to save you from counter-product negative reports to the credit bureaus. Other credit builders have different helpful perks. Mohidin explains, "Some of our non-profit partners have even better products that will match every payment you make. For example, a great credit builder product (that inspired our own!) is the LISC Twin Accounts, so be sure to check your options!"
You should shop around in your local area to see what credit builder loans are available online, at regional banks, local non-profits, or community credit unions.
Special thanks to our expert panel: