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Secured loans not only allow you to use a financial institution's funds, but they can also help you create a positive credit history. If you are just beginning to establish credit or are trying to rebuild your credit after past difficulties, opening a secured loan can help you do that.
However, you should use caution before you apply for a loan where the debt is secured by an asset you already own, such as your car. The collateral you put down can be claimed if you do not pay as agreed, leaving you in worse financial shape than before and doing harm to your credit. For this reason, only take out a secured loan when you understand how they work and when you're sure that you can meet the payments over the long term.
What Is a Secured Loan?
A secured loan is one that requires you to pledge an asset to act as a guarantee against the money you borrow. It may be cash the lender sets aside in a special deposit account, stocks and other investments, a vehicle or real estate. Whatever you use to back a loan, that security lowers the risk a lender assumes when it lets you borrow the money. In the event the loan goes into default, the lender won't have to take you to court to recoup its losses. Instead, the lender can take the collateral.
Because secured loans are less risky for lenders, you can get one even if you haven't developed a positive credit history yet, or if you already have damaged credit.
In fact, there is even a type of loan that's meant for people who need to build or rebuild their credit. It's called a credit-builder loan, and usually comes in increments of $300 to $1,000. Credit-builder loans are unique because the lender deposits the loan balance into a savings account instead of giving you the money. You are expected to make fixed payments for a predetermined number of months.The lender reports your activity to the credit credit bureaus (Experian, TransUnion and Equifax). When the loan is satisfied, the lender will give you the total balance, which may include any interest you paid. In that way, credit-builder loans are not only a way to develop good credit, but will help you save money for the future.
Are Secured Loans a Good Idea?
To determine if a secured loan is worth exploring, your first step should be to review your income and expenses carefully and make sure the payments are doable. If paying hundreds of dollars every month will be a struggle or cause you to fall behind on essential bills, a credit-builder loan is not wise. But if you can easily afford those payments for the entire life of the loan and always pay on time, the secured loan will work to your advantage.
The two most common credit scoring models, FICO® Score☉ and VantageScore, both rank payment history as the most important factor in score calculations. Making on-time secured loan payments will go a long way toward building or rebuilding your credit.
Still, secured loans are not right for everyone. Exercise even more caution if you've had past difficulties with credit. There may be bad habits that need to be broken, such as charging more than you can afford to repay or not preparing for emergencies. You're taking a great risk if you fall behind on a secured loan, and the last thing you want is for the lender to take your assets and leave you with worse credit than before.
Are There Other Options for Building Credit?
Secured loans aren't the only method you can use to build or repair credit. There are other options you can use in conjunction with or even instead of them.
- Apply for a low-limit credit card. A credit card issuer may take a chance on you if the limit is very low. Prove you can handle the account well by paying the balance in full and on time every month, and the issuer may increase the limit.
- Get a secured credit card. As with a secured loan, you put down collateral on a secured credit card. In this case it's a cash deposit, which in turn will likely become your credit limit. If you don't pay your bill, your card issuer simply keeps some or all of your deposit. Some credit card issuers will return the deposit to you and convert you to an unsecured card after you've made a number of on-time payments.
- Become an authorized user. If you know someone who has a credit card and treats it right, you could ask to be added to the account as an authorized user. That person's account activity will appear on your credit report, thus helping your own credit history. As an account guest, you won't be liable for the payments or any resulting debt, but should work out spending limits and a reimbursement plan with the primary cardholder.
- Open a loan with someone who has good credit. Becoming a cosigner with a person who has great credit can help jumpstart your own credit history. Both of you will be equally responsible for the loan, though, so it is essential that the payments are made on time. If they aren't, the lender can pursue both of you for the debt.
- Obtain a student loan. If you're a college student, positive payment history on federal student loans will help build your credit. Of course, never take out a student loan with the sole purpose of building credit, as there are much more cost-effective ways to do so. Keep making on-time payments to any student loans you already have and you can be rewarded in the long term.
- Take out an auto installment loan. If you're planning on financing a car, it's possible to obtain an affordable interest rate on an auto loan even without excellent credit. On-time payments on an auto loan will help you build your payment history. With an auto loan, the car itself is the security, so if you don't make your payments, it can be repossessed.
- Participate in a nonprofit lending circle. Check out nonprofit organizations, such as the Mission Asset Fund, that have stepped up to help low-income people build their credit. They are easy to qualify for and the lenders will report your activity with them to the credit bureaus.
- Put your rent on your reports. Some for-profit companies will send your regular rent payments to the credit bureaus. There is a fee involved, but it may be worth the cost if you really want lenders to see that you've been making regular payments to your landlord.
Bear in mind that credit scores calculate not just your payment history, but also your credit utilization ratio, which is the amount you owe on your credit cards relative to your total credit limit. A ratio above 30% will hurt your scores, and the lower the ratio, the better. Other credit score factors include the length of time you've used credit and the different types of credit products you carry. So mix it up and treat all the loans and credit cards you have responsibly!
Finally, you can try Experian Boost®ø. By signing up for this free service, you can have your cellphone, utility and other telecom bills listed on your credit report. Those payments will then factor into your Experian credit report and possibly lift your scores.
Once you've obtained more attractive credit scores, your borrowing options will expand to include the many premium products that come with low interest rates and, for credit cards, valuable rewards.