3 steps to improve your credit when it’s bad

Make yourself known to the credit reporting agencies with a credit-builder loan.

By Susan Johnston Taylor

Is this you? …

You just graduated from high school, have no credit cards and have never taken out a loan.

Or: You have just recovered from a string of bad credit luck, maybe because of an unpaid medical bill or late credit card payments.

Now, you want to build your credit so that you can buy your dream car or land that sweet apartment.

There is an answer.

Credit-builder loans are offered by some local credit unions or other financial institutions, and they’re designed to help you do just that.

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A credit-builder loan could help young adults boost their credit so they can qualify for other goals such as a mortgage or car loan. Think of it as training wheels for your credit. Of course, consumers of all ages may have difficulty qualifying for credit due to a lack of credit history. In fact, 26 million consumers in the United States were credit invisible in 2010, finds a report issued by the Consumer Financial Protection Bureau.

Or if you’ve had financial difficulties such as a foreclosure or collections actions dragging down your credit score, a credit-builder loan could help you redeem your credit and prepare to qualify for larger loans in the future. “A new positive account will not undo or erase any past negative credit history,” Michelle Black, a credit expert with HOPE4USA.com, a credit education and restoration program located in the Charlotte, North Carolina, region. “However, new positive credit accounts can certainly be a first of many steps in the right direction for someone looking to recover from the credit mistakes or setbacks of the past.”

Even if you have revolving credit such as a credit card, a credit-builder loan could help you diversify your credit mix, which accounts for 10 percent of your FICO score (the other components are timeliness of payments, length of credit history, amount owed and new credit). That’s because personal loans and mortgages are installment credit (paid back at a set amount each month), while credit cards are revolving credit, and lenders like to see that you can responsibly handle a mix of both.

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“These small-dollar loans, usually in the $500-1,000 range, are typically granted to the consumer, but the funds are held by the credit union in an interest-bearing savings account,” explains Black.

It’s a forced savings account, so you’re building credit and building savings.

Because funds are often held in a savings account, the lender bears no risk of you defaulting on the loan. “It’s a forced savings account, so you’re building credit and building savings,” says Kimberly Allen, a credit counselor with Clearpoint Credit Counseling Solutions in Williamsburg, Virginia. “That’s a good option for a lot of people.” That forced savings could help you jumpstart an emergency fund or save for bigger financial goals such as a down payment on a home.

Here are three steps to follow before and after taking out a credit-builder loan.

  1. Compare your options. Amounts, repayment terms and interest rates vary depending on the financial institution, so shop around to find the product that fits your needs. “You want to look for as long a term as possible,” Allen says. “Taking out a six-month loan, at the end of the six-month loan, is no longer helping you, so look for a term of at least a year or longer if possible.” Also consider what you can afford to pay toward the loan each month. “This is not a case of the bigger the balance the better for you,” Allen says. “Make it so that it works within your budget to make those payments. You don’t want to fall behind because that’s going to hurt [your credit].” Roughly one in five credit unions offer credit-builder loans, according to the Credit Union National Association, so don’t be afraid to compare options.
  2. Verify that the loan will be reported to all three bureaus. If your primary goal is building credit, make sure that the credit union will report your payments to all three credit bureaus, because not all credit unions do, according to Black. “If the account will only be reported to one of the credit reporting agencies, then it is probably in the consumer’s best interest to look for a credit-builder loan elsewhere,” she says.
  1. Make timely payments. Timeliness of payments makes up 35 percent of your FICO score, so make sure you don’t miss a payment or pay it late. But counter to what you might expect, you won’t get any bonus points for paying off the loan early. “You don’t want to pay it off early because that’s not helping you,” Allen says. “The whole point is to establish payment history.”

When used responsibly, credit-builder loans can help you boost your credit score so that you can ultimately qualify for other types of loans. Keep the positive momentum going by staying on top of due dates for new loans or forms of credit and not maxing out your available credit. That will help you build credit for the first time or rebuild after financial setbacks.