How to Establish Credit with a Credit Builder Loan

Getting loans, credit cards and other types of credit can be difficult for borrowers without a good credit history.

Trying to get approved for credit can be a sort of Catch-22: Creditors want proof that you’ve handled a credit card well before, but without a credit card already in hand it can be hard to show you’re a good risk.

Table of Contents:

  • What is a Credit Builder Loan?
  • How Long Is a Credit Builder Loan?
  • Who Needs a Credit Builder Loan?
  • Importance of Credit History

What Is A Credit Builder Loan

Credit-builder loans are sometimes offered by community banks and credit unions as a way to give borrowers a chance to show they can make regular payments and complete a loan, and ultimately be able to build or rebuild a positive credit history.

Credit builder accounts work like this: It’s a small loan that as you pay to yourself. You make payments that are held in an FDIC insured CD account, in your own name.

Credit-builder loans can help you establish needed credit. Using a credit-builder loan well can improve your credit score, though it can take a year to do it.

That may be OK if you don’t need a credit card or mortgage immediately, but if you need credit now or are shopping for a house, a year can be a long time to wait.

How Long Is A Credit Builder Loan?

The loans aren’t about having a need for the money being loaned, but to improve a credit score.

Loans can be small amounts such as $500 to $1,500, or some as high as $5,000. You will make payments over the term of the loan which might be a year or a different timeline.

The lender puts the payments from a traditional credit-builder loan into a certificate of deposit, which may earn interest and is given to the borrower when the loan is paid off, usually within a year. Borrowers won’t have access to the money over the length of the loan, such as 12 months.

To be clear — you don’t get the loan amount when closing the loan, as you would with a traditional loan, but get the money from the credit-builder loan when you pay off the lender completely.

Who Needs a Credit Builder Loan?

People who are trying to establish credit or rebuild credit after such major problems as bankruptcy may want a credit-builder loan. Or the loans can help people trying to build credit for the first time in their lives, such as recent college graduates, the newly divorced or immigrants new to the country.

Recent college grads, for example, who don’t have credit cards can use a credit-builder loan to establish a positive credit history and then have an easier time renting an apartment or getting a mobile phone account. These types of first-time borrowers will likely see a bigger boost in their credit score than someone who’s rebuilding their credit.

A source of income that allows monthly payments of $50 to $100 for the term of the loan is needed. Having unresolved financial judgments can make it difficult to get a credit-builder loan.

If you have unresolved financial judgments against you, it can be difficult to get a credit-builder loan. Pay those debts off first before applying for one.

Importance of Credit History

Good credit history is one of the major parts of what makes up your credit score. Did you know payment history makes up 35% of your FICO score?!

Ultimately, credit-builder loans are a great first step which might lead to getting unsecured credit cards or larger loans such as a car loan within a few years. And then, with a good or excellent credit score in hand, you’re more likely to get the best loan rates and possibly the best credit cards as lenders seek out your business.

How to Build Credit as a College Student

Building good credit in college is one of the best financial moves students can make. Having good credit allows them to qualify for loans, rental applications, auto insurance, phone plans and can help them get a job.

Improving a credit score can be a Catch-22: Your score won’t go up until you have a good score.

Being responsible with credit is the best way to establish and improve a credit score. For college students without much credit history, there are small but important steps they can take to show how responsible they are with credit. And, they can be done without going into debt.

Ways To Build Credit As A College Student

Here are some ways to be responsible with credit as a college student and start building a credit score:

Store Credit Card

An easy way to get a credit card is through a store. Department stores such as Kohl’s and Nordstrom often offer them to customers at the checkout line.

The big caveat — and this is true with all credit cards — is to pay the bill in full on time each month. Retail credit cards have higher interest rates than regular credit cards, so you could be bigger debt with a retail card if you don’t pay on time than you would with another card.

The upside is that retail cards can only be used at the issuing retailer, so you can’t use it to pay for a vacation.

Secured Credit Card

If you want to avoid the enticement of a store credit card, go to your bank and get a secured credit card. For people with poor credit history or no credit, such as college students, a secured credit card can provide the financial security that they won’t spend more than they can afford.

A secured credit card requires a deposit, such as $500, that is the user’s credit limit. If a credit card payment isn’t made, the card issuer pulls money from the deposit.
To get the most out of it, cardholders should use as little of the available credit as they can. This will leave them with a low credit utilization rate, which can improve their credit score. The best thing they can do is not miss any payments, since late or missed payments have the biggest impact on a credit score.

The credit reporting agencies will look at a secured credit card with the same criteria as an unsecured card. These include when the card was opened, the credit limit, balance and payment history. The benefit is that a secured credit card should be easier to qualify for so that a consumer can build their credit.

Just like unsecured credit cards, secured cards can have annual fees. Eventually, holders of secured credit cards should see their credit score improve enough so that they qualify for an unsecured credit card with a higher credit limit.

Student Credit Card

Some credit cards are marketed to students and others who don’t have much borrowing history. Federal laws restrict issuing credit cards to anyone under 21 unless the applicant has the independent ability to repay debt or has an adult co-signer who accepts joint liability for the account.

Student credit cards may have low credit limits, such as $1,000. Otherwise, they may be indistinguishable from other credit cards and may have features such as cash back, no annual fee and budget management tools.

Regular Credit Card

If you can qualify, a regular credit card should be your next step in achieving credit and using it well. A regular credit card will have a higher credit limit than any of the cards above, and can offer better rewards programs.

It’s important to do some research first. Look for a card that has a low interest rate, no annual fees, good credit limits and clear billing policies.
If you expect to carry a balance, get a no-frills, low interest credit card. Reward credit cards often have higher interest rates and annual fees that can offset some of the rewards.

How To Best Use Any Credit Card As A College Student

After getting any of the above credit cards, start using it with baby steps. Use it for occasional, small purchases that you can pay for on time. This will help build your credit history and help keep you out of debt.

Don’t let a new card sit in your wallet. Use it or the bank may close it due to inactivity. Put small, recurring charges on it, such as a Netflix account or other website subscriptions you regularly use.

Don’t make any big purchases unless it’s an emergency. Having low debt levels on your credit card will allow you to have enough of a credit line available in an emergency, and will increase the credit utilization part of your credit score.

This should go without saying, but pay off your credit card balance each month and only buy what you can afford. Also, pay all of your other bills on time. Rental and utility payments that aren’t paid on time may be listed on a credit report. Even an unpaid traffic ticket could come back to haunt you.

Lastly, don’t apply for several credit cards at the same time, especially if you’ve just started establishing credit. This can be a sign that you’re desperate for money and can lower your credit score. One credit card should be enough for college students, and should make it easier to keep a handle on debt.

Building Credit With Student Loans

One of the last things you want to do as a college student or graduate to hurt your credit score is to default on your student loans.

Make at least the minimum payment each month and do it on time. Borrow only for what you need to go to school, such as tuition, and not to buy a car or dine out. Once you graduate, you may want to consolidate your student loans to get a better interest rate.

On-time payments and paying off your student loans will improve your credit score over time. If you run into problems making payments, contact your student loan provider and ask for forbearance. Federal student loans also offer Income-Driven Repayment plans, or IDR, that base payment on a borrower’s income.

When contacting a student loan servicer, do it in writing so there’s a paper trail that may help solve problems later. Some lenders provide a slight interest rate reduction for student loans set up to be paid through automatic payments.

Does Being an Authorized User Help Your Credit Score?

I have been receiving a lot of emails from folks asking how authorizing another person (usually a friend or relative) on their credit card will affect both party’s credit score. Back in the day, becoming an authorized user on another person’s credit card was a great way to build your credit.

Things have changed in recent years and even though being an authorized user is a great tool for building credit, there are a few things that have changed.

Let’s get into the details of how you should use this credit-building tool to your advantage.

What Does Being an Authorized User Mean?

When you become an authorized user on another person’s credit card account, you’re issued a credit card in your name.

You’re able to use this credit card in the same way that the primary user uses it, however, you’re not legally obligated to pay the debt.

The primary user is responsible for paying the debt on the credit card. This also means that if you’re an authorized user and you use the credit card irresponsibly, the primary user is on the hook for it. I’ll get more into this later.

Generally, the reason why a person becomes an authorized user on another person’s credit card rather than just getting a credit card in their own name is that the person has poor credit and wouldn’t be approved.

Being an Authorized User to Help Build Credit

Several years ago it was a common credit repair practice to become an authorized user in order to rebuild your credit. However, the algorithm used to generate your FICO score no longer factors this into the equation.

In other words, being an authorized user is still a good tool for establishing your credit if you don’t have any credit history, but won’t really help you rebuild your score if you have poor credit due to negative entries.

The best way to improve your credit score if you have poor credit is to get a secured credit card and remove negative entries on your credit report.

I also want to note that being an authorized user isn’t going to have a huge impact on your credit score if you don’t have any prior credit history, but it will help, so why not take advantage of it?

Again, I suggest using the technique of becoming an authorized user as a tool for establishing good credit rather than rebuilding bad credit.

There is a big difference and many people make the mistake of thinking that they are going to improve their bad credit by becoming an authorized user on their spouse’s credit card. It simply won’t impact your bad credit.

Sign Up for a Joint Account Instead

While creditors may look more closely at a credit score when opening a joint account, setting up one of these accounts can be a much safer bet. Plus, both people will see the positive credit score gains!! And, since it’s a joint account, both people are responsible for the payment and both names are on the account.

Adding an Authorized User is Risky

Lastly, I want to give out a sincere word of caution of those who of you who are considering letting another person become an authorized user on your credit card.

I’ve been running this blog of over 10 years and I’ve literally received hundreds of emails from readers who tell me that they let a family member become an authorized user, the family member ran up the credit card bill and now they are on the hook for a bill they can’t afford.

You have to realize that there’s a real possibility that this will happen to you. I’m not saying your family member will intentionally harm you financially but this type of stuff happens all the time and you need to keep in mind the risk you are taking by allowing somebody to use credit in your name.

That said, if you truly want to help out a young family member, perhaps your college bound son or daughter, letting them become an authorized user on your credit card is a tool that will help them build some positive credit history.

How To Build Credit When You Have None

You can find a lot of bad information online about building credit history when you’ve never used any credit before.

I’d like to tell you the best ways to start building credit. Building credit the right way takes a few months but it is easy when you follow these steps.

Building Credit 101: Dos and Dont’s

These strategies also apply if you’re trying to rebuild credit and improve your overall credit score.

Don’t: Become an Authorized Users

Years ago the common credit building advice for college students and young adults with no credit was this: Become an authorized user on someone else’s credit card.

You can still become an authorized user on a friend or family member’s credit card account. But won’t help your credit very much, if at all.

Authorized users of a credit account are not responsible for paying the bill; only the primary cardholder or co-applicant will be responsible.

Therefore, authorized users do not record positive credit history when the credit card gets paid.

Nonetheless, you still hear countless people tell you this is the first thing you should do. They aren’t lying; their info is just outdated. That’s OK 🙂

Don’t: Apply For A Major Credit Card Yet

When you don’t have any credit history, major credit cards like American Express, Discover, Chase, and Citi will deny your application.

But it never hurts to apply, right? Well, actually, it can hurt. The rejected applications can become part of your credit history.

Any time you apply for a credit card, the lender checks your credit. This check shows up as a hard inquiry in your credit file with Experian, Equifax, and TransUnion.

Multiple hard inquiries in a year will lower your credit score, undermining your credit building process before it gets started.

That being said, sometimes a major credit card company will send you a pre-approved offer even if you don’t have any credit. The truth is, you might get accepted.

But I wouldn’t recommend going this route. A secured credit card lets you add positive history to your credit report without risking out-of-control bills.

Get a Free Copy of Your Credit Report

Do: Start With A Secured Card

You could think of a secured credit card as a debit card that builds your credit history.

With a secured credit card the lender does not extend a line of credit. Instead, you make a security deposit which you can spend via the credit card and then pay off.

Yes, you have to fund your own line of credit, but the credit card company reports your payment history to the credit bureaus each month.

So you can start building credit by making on-time payments without risking debt.

This strategy offers several advantages:

  • It’s a Safe Bet: You can’t get into too much trouble when you fund your own line of credit — unlike with a $5,000 credit limit on an American Express or Discover card.
  • You Can Make a Small Deposit: You could make a deposit as low as $200 on your secured card. Remember, this card isn’t designed to enhance your borrowing power. The whole point is to start sending positive credit data to the bureaus so you can achieve a good credit score.
  • Fees Aren’t Punitive: Most secured credit cards charge an annual fee. But compared to unsecured credit cards for people with bad credit, the fees are manageable. Plus, bad credit card accounts have low available credit limits, too.

This should go without saying, but it won’t hurt to remind you: Failing to make on-time payments on your secured credit card each month will hurt your credit.

I recommend paying off the entire balance each month.

Do: Consider Credit Builder Loans

Anyone trying to establish or rebuild credit after bankruptcy should consider a credit builder loan.

This is a loan designed specifically for people building credit for the first time in their lives.

College graduates, people who are newly divorced, and immigrants who are new to the country could all benefit from a small credit builder loan.

Here’s how these loans help first-time borrowers.

  1. Your bank or credit union approves your credit builder loan.
  2. Funds from the loan get dispersed directly into a savings account you don’t access.
  3. Each month the bank withdraws the loan’s monthly payment and reports your on-time payment to the credit bureaus.

With these loans, you’re pretty much guaranteed to make on-time payments month after month — which helps build 35% of your FICO score.

People with no credit history will start to see big increases in their credit scores after a few months.

People with bad credit will make slower progress because their positive payment history has to overcome existing negative credit information.

Do: Consider Applying with a Co-Signer

I saved this common credit building method for last because it’s my least favorite.

When you ask a parent or a friend to co-sign on your auto loan or personal loan, you’re asking that person to put his or her own credit on the line for you.

If you fail to make on-time payments, your co-signer’s credit report will suffer along with yours.

Still, under the right circumstances, this method can help you build your own credit history with the major credit bureaus.

Whether you need a private student loan, car loan, credit card, or personal loan, a family member with good or excellent credit could help you secure the loan by co-signing.

Along with getting access to the money you need, you’ll have a chance to build a positive payment history.

I recommend setting up automatic payments from your bank account or at least putting the loan’s due dates on your calendar.

Getting behind on the payments could strain your relationship with your co-signer.

Elements of a Healthy Credit Score

When you’ve graduated from the dos and don’ts of credit building by getting a secured credit card and a credit builder loan, you’ll have a living, breathing credit file within six months.

At that point, you’re ready to fine tune your credit life so your credit score can soar.

With excellent credit, you can choose loans and new credit cards with lower interest rates and lower fees.

The best credit cards pay you to use them through rewards dollars.

Here’s how to achieve these goals:

Keep That Payment History Perfect

Once you have your secured credit card account open and in use, make the monthly payment, on-time, every month.

Spend your self-funded line of credit and then pay it off. Rinse and repeat.

When I had my secured credit card I used it for only gas. This meant I made regular transactions but never over-spent.

If you already have student loans, rent payments, cell phone bills, and utility bills, pay these bills on time, too.

The FICO and VantageScore models emphasize payment history, especially on credit cards and personal loans.

  • By keeping a perfect payment history, you’re keeping 35% of your credit score in great shape.
  • By making late payments or missing payments, you’d be harming 35% of your credit score.

If you’ve started out with no credit history, you can expect to see credit score increases within six months of making all on-time payments.

If you’re rebuilding bad credit, expect this process to take longer — possibly a couple years.

People will say you can build credit fast. This just isn’t true.

Keep Your Balances Paid Down

Another 30% of your FICO comes from your credit utilization ratio.

This is a fancy term that measures how much of your available credit you’re using month to month.

Someone who has spent $2,500 of a $5,000 line of credit is using half his or her available credit. This credit utilization ratio would be 50%.

Most personal finance experts recommend keeping your credit utilization rate below 30%. I’d go as far as saying 25%.

Once you exceed the 30% threshold, FICO and VantageScore start to lower your credit score.

A credit utilization rate approaching 100% will really start dragging down your credit score.

This rule applies best to revolving credit accounts like credit cards and overdraft protection lines of credit.I

t’s a lot harder to control the balances on installment loans.

Keep a Few Paid-Off Accounts Open

Along with paying down balances, you can help your credit utilization rate by keeping a few unused accounts open.

If you’ve paid off a Visa and plan to close the account, for example, consider keeping the account open but not using it.

Having a card with a 0% credit utilization rate looks really good in your credit history. Once again, your credit utilization rate fuels 30% of your credit score.

Other Ways to Fine Tune Your Credit History

So you know that 35% of your FICO comes from payment history and another 30% from credit utilization. That’s 65%. What about the other 35%?

  • Age of Credit Accounts (15%): Keeping some older accounts open will help here. When you’re first trying to build a good credit history you’ll have to be patient with this.
  • New Credit Inquiries (10%): Like I said above, applying for a new credit card or loan gets recorded on your credit report. Too many hard inquiries in a short period of time can pull down your score.
  • Types of Credit (10%): Keeping a good mix of types of credit will help your credit score. If you already have a student loan and you’ve added your first credit card, you’re already diversifying your types of credit. Adding a mortgage, a car loan, a store card, or a personal loan in the future will help even more.

Protecting Your Good Credit History

The time you spend building credit will pay off well into the future only if you keep a good credit history by protecting your credit profile.

Here’s how:

Credit Monitoring is a Must

Identity fraud is so prevalent in the 21st century. A data breach or stolen credit card could wreck your credit fast.

Financial institutions have increased their security measures in response, but you still have to take responsibility for monitoring your own credit so you can detect problems before they become disasters.

Fortunately, there are many ways to monitor your credit, including several free tools.

First, you can get free copies of your actual credit reports by visiting annualcreditreport.com.

Or, you could get a free credit score from apps such as Credit Sesame and Credit Karma which track your VantageScore. (Your VantageScore often resembles your FICO score.)

These apps can alert you about possible fraud. At that point, it’s up to you to take action to freeze your credit and investigate the problem.

If you want more robust protection, the three credit bureaus have subscription-based credit monitoring and identity theft services.

I like TransUnion’s program and have also heard good things about Experian Boost.

Learn More about TransUnion

Remove Inaccurate Negative Items

If your credit report shows a sudden decrease, you may have inaccurate negative items pulling down your credit score.

Sometimes lenders report late payments inaccurately. Or they don’t update Experian, Equifax, and TransUnion when you’ve paid off your balance.

Occasionally people have accounts on their credit report that they never opened because a lender sent in the wrong Social Security number or mixed up some similar names.

You can dispute inaccurate negative items with the credit bureaus, and you can ask the lender to correct the mistake.

Removing inaccurate negative information from your credit report can resuscitate your score quickly. Monitoring your credit reports helps you detect these kinds of problems early.

Keep Credit Card Debt In Check

You learned about good payment history habits with your secured credit card, but a secured card’s low “credit limit” won’t teach you much about self-control.

When you’ve been successful building credit, you’ll suddenly have access to large available credit limits on multiple cards. You could have $30,000 or $50,000 in available credit.

If you dive too deeply into these credit limits, you’ll soon have dead weight pulling on your good credit history in the form of a high credit utilization rate.

Your minimum payments won’t put a dent in your balances, and your credit card issuers will start piling on the finance charges at high interest rates.

At this point you’re vulnerable. A setback like a big car repair or lost wages from an illness means you may have to make a late payment or miss a payment or two. Then the late fees and punitive interest rates kick in.

You see where this is going. Many credit scores have been decimated by late payments that lead to credit card charge-offs and collection accounts.

Avoid overspending!

Your Goal: Credit that Works for You

Now you know the elements of your FICO score and tools you can use to build credit history.

It’s time to use this knowledge by putting it all together.

Building credit is all about building momentum. Every month is a new opportunity for the credit bureaus to receive positive information about you.

Month after month, and year after year, layer by layer, your credit history will grow a little stronger. Then, the components of your credit score start working together, interdependently, in your favor:

  • Keeping a low credit utilization rate requires making on-time payments which boosts your payment history.
  • When you get your credit rolling and keep up the momentum over a couple years, you’ll have excellent credit. People with excellent credit have access to the best financial products with the lowest interest rates, the lowest fees, and the highest spending limits.
  • Higher credit limits can lower your credit utilization ratio which raises your credit score even more.

You can see where this is going. Momentum.

I wish you all the best luck and let me know how it works out.

Also, if any of you want to share your experiences, please do so below!