If you’re trying to build your credit, you may encounter a bit of a Catch-22: You likely need a good credit history to successfully apply for credit. But how do you do that if you don’t have credit?
Fortunately, products like credit builder loans and secured credit cards can help you build a favorable credit profile if you’re still at the beginning of your journey. Deciding which of these financial products is best will depend on your immediate financial needs and how much cash you have available to put down for a security deposit.
Read on to learn more, including:
• What is a credit builder loan?
• How does a credit builder loan work?
• What are the pros and cons of credit builder loans?
• What is a secured credit card?
• How does a secured credit card work?
• What are the pros and cons of secured credit cards?
• Which is better of a secured credit card vs. a credit builder loan?
What Is a Secured Credit Card?
Secured credit cards vs. unsecured credit cards may look the same, but they work a little differently.
Instead of setting a credit limit determined by your credit history, secured cards require a cash security deposit. The amount of your deposit is usually the same as your limit.
You can think of it this way: Rather than allowing you to borrow money, the credit issuer is essentially allowing you to spend money you already have. It may sound as if it doesn’t offer any benefit, but remember: This gives you the opportunity to build your credit.
How Secured Credit Cards Work
When you apply for a secured credit card, you’ll provide your basic demographic information along with a cash security deposit to the card issuer. This deposit will usually be at least $200 or $300 and could be more; say, $1,000 or $2,500.
The deposit amount will likely serve as your working credit limit, though you may want to use the card sparingly. Perhaps you swipe or tap it often enough to keep it open and for the credit bureaus to see your positive credit behavior, such as paying in full and on time each month.
Because the cash deposit works as collateral, lowering the risk for the card issuer, you may be able to successfully apply for a secured credit card with a lower credit score or possibly even no credit at all. The same issuer might even automatically review the account to see if it merits a switch to an unsecured card.
Recommended: How to Apply for a Credit Card
Secured Credit Card’s Effect on Credit
Secured credit cards offer you the opportunity to build positive credit history, since your balance, payments, and other information will be passed to the credit bureaus. And because the credit limits are generally lower, it’s a lot harder to fall into a serious debt spiral with a secured credit card than it is with an unsecured one.
Pros and Cons of Secured Credit Cards
Like any financial option, secured credit cards have both pros and cons to consider.
Pros of secured credit cards:
• It’s a readily available way for those with poor or non-existent credit history to begin building their credit with a low cash deposit.
• You gain the ability to use the funds immediately while still building credit over time.
• You may gain some potential credit card benefits, such as fraud protection and credit card rewards, like cash back.
Cons of secured credit cards:
• You must have the cash deposit available, and it can be in your best interest not to use the entire amount once you have the credit card. That means some of your money is tied up on the card.
• Interest and penalties may apply if you aren’t able to keep your balance low or paid off in full each month.
• Card issuers do still run a hard credit inquiry when you apply, which can negatively impact your credit in the short term.
What Are Credit Builder Loans?
Credit builder loans are another option for people looking to build their credit. They work a little differently than a traditional loan does. Rather than receiving the money you’ve applied for right away, you’ll get the money later, after you’ve repaid the full amount.
How Do Credit Builder Loans Work?
Applying for a credit builder loan is a lot like applying for any other unsecured or secured personal loan. You’ll provide a variety of information, including details about your existing monthly expenses and income, as part of the approval process. (The lender may or may not run a credit check or look into your banking history.)
These loans are typically for relatively small amounts of $300 to $1,000. The term is likely to be between six and 24 months; rates will vary.
If you’re approved, the bank will create a savings account or certificate of deposit (CD) in the amount of the loan. The money is held there rather than paid out to you, and you repay the debt over time. It’s only when you’ve successfully completed repayment that the money be disbursed to you (sometimes including accrued interest).
In this way, it’s kind of like an enforced savings plan: You could slowly put money away into a savings account yourself, but taking out a credit builder loan keeps you accountable.
Plus, your payments are reported to the credit bureaus, which means you have the opportunity to build your credit history and credit report in the meantime. Win-win!
Note: Credit builder loans may not be available at your financial institution. If that’s the case, check credit unions, CDFIs (Community Development Financial Institutions), and online lenders.
Credit Builder Loan’s Effect on Credit
The loan company will report your on-time payments to the credit bureaus, which can help you build your credit. This can make it a lot easier to take out other loans in the future.
Of course, if you fail to pay on time or default, a credit builder loan could have a negative effect on your credit.
Pros and Cons of Credit Builder Loans
Credit builder loans also have both positives and negatives to consider.
Pros of credit builder loans:
• They are available to people with low or no credit.
• They may not require a hard credit inquiry.
• They can help people build credit without risking going into credit card debt.
Cons of Credit Builder loans:
• You won’t have access to the funds until after you’ve paid the loan off. Credit builder loans might not be right for those who have immediate financial needs.
• There may be a nonrefundable fee for taking out the loan.
• These loans can be difficult to find.
Credit Builder Loans vs Secured Credit Cards
Which of these two credit-building options might be right for you? The answer depends on your circumstances, but this table might prove helpful in comparing the options.
|Credit Builder Loans||Secured Credit Cards|
|Your money will be locked up until you pay off the loan||You’ll have immediate access to funds but not the full amount of the deposit|
|May come with a one-time fee, but doesn’t pose the financial risk of revolving debt||Can be easy to accrue interest, late fees, and other penalties|
|Required cash security deposit can be as low as a few hundred dollars||Required cash security deposit can be as low as a few hundred dollars|
|Available to those with poor or non-existent credit||Available to those with poor or non-existent credit|
|Can help build credit history over time||Can help build credit history over time|
Is a Secured Credit Card or Credit Builder Loan Right for You?
Depending on your specific financial circumstances, either of these products might be a valuable way to enhance or establish your credit. Both are relatively easy to access for those with imperfect financial histories. Although both require an up-front cash deposit, the deposit may only be a few hundred dollars.
If you need to use your money right away, a secured credit card may make more sense; you’ll be able to use your credit card to pay bills and cover other expenses.
A credit builder loan, on the other hand, ties up your money for a longer period of time, but comes with less risk of paying large amounts of interest on revolving debt.
Credit builder loans and secured credit cards make it possible to create a favorable credit history. A credit builder loan may be a better option for those who have more cash available, whereas a secured credit card helps build credit while (responsibly) spending.
What is the difference between a credit builder loan and a secured credit card?
A credit builder loan is a loan that disburses money to the borrower only once the entire amount has been paid to the bank. A secured credit card is a credit card that requires a cash deposit to open. Both of these strategies require an up-front cash investment, but they also give people with poor or nonexistent credit the opportunity to build positive credit history and improve their credit score.
Which is better for building credit: a loan or a credit card?
Both loans and credit cards can build credit over time if the borrower makes their payments on-time and in full. However, both can also pose risk if the borrower is unable to keep up with repayment. Deciding whether to get a credit builder loan or a secured credit card may depend on how soon you need access to your cash.
What is one disadvantage of a credit builder loan?
When you take out a credit builder loan, you won’t have access to the money you’re applying for until the loan’s term is up, which may be as long as 24 months. That means credit builder loans might not be right for people with short-term financial needs to take care of.
Photo credit: iStock/staticnak1983
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