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You know using credit responsibly can help build or improve your credit score. But how are you supposed to build credit if your low credit score means you can't get approved for a traditional credit card or loan?
Thankfully, there are alternatives. Credit-builder loans and secured credit cards are viable options available to those who lack much credit history, or have negative marks against them. Deciding which is best can depend on how much you have available for a security deposit and if you need access to the funds right away.
What Is a Credit-Builder Loan?
Instead of receiving funds if you're approved, the lender puts the loan amount into a savings account. You'll make payments to the lender for six to 24 months, depending on the loan term. Once the loan term is up, the full amount of the loan is disbursed to you. (Some lenders also return the interest that accrued while you were repaying the loan.)
Each payment you make is reported to the three major credit bureaus (Experian, TransUnion and Equifax) to help build your credit. Making every payment on time can help you prove yourself as a responsible borrower and increase your credit scores.
Credit-builder loans are offered by credit unions, community banks, online lenders and lending circles. They are usually available in increments of $300 to $1,000.
When you apply, most lenders will ask you to provide the following:
- Employment information
- Income (pay stubs if you're employed or tax returns if you're self-employed)
- Monthly housing payments
- Outstanding balances on existing loans
- Checking and savings account balances
- Personal references
Some lenders do not require a credit check when applying for a credit-builder loan. Still, they may review your banking history through ChexSystems. So, you could get approved if you have less-than-perfect credit but exceptional banking history.
What Is a Secured Credit Card?
A secured credit card is another option that can help you build or rebuild your credit. These cards are designed for risky consumers who may have trouble qualifying for traditional credit cards because they have minimal or no credit history or bad credit.
Secured cards differ from traditional unsecured cards because you'll be required to put down a refundable security deposit when opening the account. This deposit is usually equivalent to the credit limit you'll have on the card, but some credit card issuers will grant a credit limit that's higher than your initial deposit or raise your limit later on without an additional deposit. If you default on your payments, you'll face credit consequences and lose your deposit.
You are free to use the card as you see fit up to the credit limit. The security deposit will remain on file unless you close the card or the creditor decides to upgrade you to an unsecured account. Either way, the deposit will be refunded to you if the account is closed in good standing.
Secured credit cards are offered by traditional banks, online banks, credit unions and other financial institutions. You can get a card by applying on the card issuer's website or visiting a brick-and-mortar branch (if applicable). In most instances, you will receive a credit decision in minutes. If you're having trouble finding a secured credit card, Experian CreditMatch™ can help you explore your options.
Which Option Is Best?
Are you torn between a credit-builder loan and a secured credit card? The best option for you will depend on your needs, financial situation and other factors.
Credit-builder loans may be a better fit if you want to save money while establishing or rebuilding your credit. They're also sometimes preferred over secured credit cards because they may not require a credit check and you may pay less in interest for a credit-builder loan than a secured card. In addition, you won't have to worry about the upfront cost associated with a secured credit card if you choose a credit-builder loan.
However, secured credit cards could be more ideal if you require a bit more flexibility. They can be used like regular credit cards, and some offer benefits, like travel and purchase protections and cash back rewards.
Plus, some secured credit card issuers review accounts occasionally and sometimes grant credit limit increases without requiring an additional deposit. There's a possibility the card can be converted to an unsecured product, which means the credit card issuer will return your security deposit. This is good news if you initially wanted a traditional credit card but didn't qualify because of your credit history.
How to Build and Establish Credit
Credit-builder loans and secured credit cards are just two ways to build and establish credit. There are other strategies you can use to boost and maintain your credit score. But first, you should understand what affects your credit score. Your FICO® credit score, the one most commonly used by lenders, is made up of five factors:
- Payment history (35% of your score): Your payment history is the most important factor in your credit score. Lenders want to know their borrowers will be reliable in paying back their debts, and a long history of on-time payments lets them know that.
- Credit utilization (30% of your score): This measures the balances on your revolving debt accounts (credit cards or lines of credit) compared with your borrowing limits. Creditors like to see this number at 30% or lower, but the lower, the better for your scores.
- Length of credit history (15% of your score): The length of time you've been managing credit accounts also plays a role in your scores. This factor includes the age of your newest and oldest accounts and the average age for all of them. A lengthy credit history is good for your credit health.
- Credit mix (10% of your score): Creditors like to see a mix of revolving (credit cards) and installment accounts (car loans, student loans, mortgages). A blended portfolio of credit accounts may help boost your score.
- New credit (10% of your score): This includes the number of recently opened accounts and hard inquiries generated each time you apply for credit. Many recent hard inquiries and new accounts can affect your credit approval.
Once you understand what affects credit, the next step is to build good credit habits to improve and maintain your score. Make it a habit to pay your bills on time, keep your credit utilization low and only apply for new credit as needed. You should also monitor your credit often to keep tabs on your credit health. Doing so allows you to fix any issues right away that may come up.
It's equally important to avoid credit mistakes to preserve your score and overall credit health. If possible, refrain from making late payments and try to pay more than the minimum on your credit cards each month. Also, avoid installment loans with extended terms as they generally mean you'll pay more in interest over the life of the loan.
Here are additional tips to help lift your credit profile:
- Become an authorized user. You could ask a relative or friend with good credit to add you as an authorized user to one of their accounts. The positive payment history will be added to your credit report and could help strengthen your score. You are not responsible for charges made on the card and can request to be removed as an authorized user at any time.
- Ask your landlord and service providers to report to the credit bureaus. These accounts usually won't appear on your credit report unless they go to collections. However, if you pay your rent and utilities on time, your score could improve if the landlord and service providers report payment activity to the credit bureaus.
- Request a higher credit limit. The credit card issuer may agree to increase your credit limit if your account is in good standing or your balance is low. A higher credit limit will raise your overall available credit and reduce your utilization, which can help improve your score.
- Look for a cosigner. Having a trusted friend of family member add their name to your account could help you qualify for credit you otherwise wouldn't. A cosigner can also help lower your interest rate and improve your terms. Few credit card issuers allow cosigners on accounts, but this can be a simple way to qualify for a loan that's out of reach for you on your own. An account with a cosigner helps you build credit like one without, but your account management will also reflect on your cosigners credit as well. Tread carefully if you're not sure you can afford to pay back an account with a cosigner, as you risk compromising the relationship in addition to your credit.
The Bottom Line
Credit-builder loans and secured credit cards are both suitable options to establish or build your credit. Before you decide which is best, compare the benefits and drawbacks of each. Also, know that these products aren't the only way to improve your credit health.
Experian Boost®ø can boost your scores fast by adding the positive payment history for your utility and cellphone bills and other payments to your credit report. You can sign up for this free service in minutes at no cost.