What is a credit builder loan and how does it work?

Are you struggling to get your loan approved because you have a poor or non-existent credit history?

Financial institutions offer credit builder loans to enable you to improve your credit score. This increases your chances of availing of credit products from lenders.

Is that a lot of jargon? Wondering what is a credit score and how a credit builder loan can help you? This article will help you with everything you need to know about credit builder loans.

As soon as you open a financial services website or even think of securing a loan, you start coming across calculators to know your credit score. You may not realize the importance of building credit until you need a loan. Imagine being in dire need of money to fulfill a dream or meet an emergency only to be told that you are not eligible for a loan. It is worse if you are amidst a financial crisis and there isn’t a way out.

A credit card, a loan for your dream home, or a personal loan, your possibility of getting any of these depends on your credit history. It is a parameter that lenders rely on to assess if you are eligible for a new financial product.

Many employers also check credit reports as a part of their background checks. Whether they hire you or not will depend on your credit score.

Apart from these situations, a good credit score also helps you to secure loans at low rates of interest, avail of credit card bonuses, or get approval for a new credit card. Building a credit score early and maintaining it, is an important aspect of your financial health. It ensures that you have access to credit whenever you need it.

Understanding credit score

A credit score is a number that determines your eligibility for credit. It is calculated based on your credit repayment performance in the past. The more regular you are with your repayment schedules, the higher your credit score. A high credit score is an assurance to the lenders that the risk involved with lending money is low.

While many of us understand the importance of building credit, it may not always be possible to maintain a good score. A lack of understanding of credit score and its importance or emergencies may lead to a bad credit score. This makes it difficult to avail credit and can lead to frustration and distress.

The good news, however, is that you can rebuild your credit.

Rebuilding Credit

Your credit score is a direct result of your credit actions and just as it went down, it can be brought up too. Some ways to rebuild your credit include staying on track with repayments of existing loans, repaying outstanding loans, keeping the credit utilization ratio low, etc. However, all these options apply to those who already have access to some credit products. This may distress individuals who cannot access credit products because of their low credit scores. Opting for a credit builder loan is the perfect way for such people to improve their credit scores.

What is a Credit Builder Loan?

Whether you are new to credit or are trying to improve your low credit score, a credit builder loan is ideal for you. It is the right choice for individuals who do not have an asset to take a loan against or are not eligible for any credit products.

Your credit score improves only if you pay back your loan EMIs in time and establish creditworthiness. Credit builder loans can enable you to do that. Lenders offering credit builder loans lend you a small amount and allow you to pay it back in regular installments over a fixed duration. These regular repayments help to improve your credit score.

To apply for a credit builder loan, you must approach a lender offering a credit builder loan. They will assess your creditworthiness based on your employment status, monthly income, tax returns data, bank balance, presence on social media, your bank transactions, etc. Some banks lend credit-building loans to account holders in their bank to minimize risk.

Credit builder loans are just like personal loans. However, the maximum amount that can be availed is a lot lower and the tenure is also shorter.

Borrowers can get a small amount as a 6-month credit builder loan and repay it in installments. Some lenders also allow a repayment period of 12 months.

Timely payment of these installments will reflect in your credit score.

How do Credit Builder Loans work?

Once you apply for a credit builder loan and it is approved, your lender will set aside the decided loan amount for you. This amount is either saved in a certificate of deposit or locked away in your savings bank account. As opposed to regular loans, you will not be able to access this amount until you pay off all the installments. As you make timely monthly payments, the lender will report to the major credit bureaus. At the end of the repayment period, your credit score will have improved, and your lender will unlock the amount for you.

These loans are different from other loan types because you get access to the borrowed amount only after you have repaid it.

Types of Credit Builder loans

Different lenders offer different types of credit builder loans. They include the following:

Pure Credit Builder Loan - If you are opting for a pure credit builder loan, the loan amount will be credited to your savings account, but you won’t have access to it. You need to pay the amount as EMIs along with interest over the tenure of the loan. Once the loan tenure is over, you will get your money. However, the bank charges a nominal fee for this arrangement and reports the timely repayment to the body governing credit score.

Secured Credit Builder Loan - This loan uses the existing amount in your savings account as security. This amount will stay locked throughout the loan tenure, and you cannot use it until you repay the complete amount. The rate of interest is lower for these loans.

Unsecured Credit Builder Loan - Some credit builder loans follow this format. They credit the loan amount in your account just as with personal loans and you must repay based on the repayment schedule. The rate of interest on these loans is usually higher.

Benefits of credit builder loans

While the prospect of a credit-free life may sound ideal, it isn’t always practical. You may need a loan to fulfill your goals such as buying a house, buying your favorite automobile, getting a degree, or for unforeseen medical expenses. Not being eligible for a loan when you need it will only add to your frustration. Credit builder loans help to avoid such situations. They also help you to save money. Once you have paid all the installments of your credit builder loan you will have a sizable sum of money at your disposal. Once your credit score is good, you will be able to avail other loan products at low-interest rates. This will also help to inculcate financial discipline and you will be more careful about loan repayments in the future.

Important things to remember about credit-builder loans

● Missed payments will impact your credit: Opt for a credit builder loan only if you can afford the payments. This is because failure or delay to pay an installment will affect your credit score adversely and that will go against the purpose of availing a credit builder loan.

● Do not prepay your credit builder loan: While most lenders will allow prepayment of credit builder loans, it doesn’t make sense to do so. This is because the idea behind these loans is to build your credit with each repayment and paying early will cut short the history of timely repayments. The lender may also charge you a prepayment penalty.

● Interest on credit builder loans: The EMIs that you need to pay for your availed loan amount include an interest component apart from a portion of principal. While some lenders lock the amount in your savings account and it earns interest, the interest earned is often significantly lower than what you need to pay.

Financial institutions that offer credit builder loans

If you wish to rebuild your credit, you can seek a credit builder loan from Credit Unions, community banks, lending circles, or online lenders. IndiaLends offers credit builder loans online and can help you improve your credit score. A dedicated relationship manager will work with you to come up with a personalized credit builder program. It is a quick, easy, and hassle-free way to increase your likelihood of getting a loan and fulfilling your goals.

The bottom line

Remember, credit builder loans can bail you out of tough financial situations but are not a replacement for financial discipline. Once your credit score is back on track, be regular with your repayments and you may want to ensure that such a situation doesn’t arise again.