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Using credit-builder loans to boost your credit and savings comes with a big catch

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Many Americans are burdened by bad credit and nearly three in 10 adults have no emergency savings at all. One product seems to help resolve both issues at the same time: a credit-builder loan.

Typically offered by credit unions and community banks, credit-builder loans allow consumers to borrow money and pay it back in monthly installments. Borrowed funds are locked up in a secure savings account that becomes accessible once the loan is repaid in full.

While there’s an opportunity to build credit and save money, there are some downsides to having a credit-builder loan. The savings account, for example, is an added benefit but won’t completely solve the problem of a lack of savings for a rainy day.

“It’s a credit-building product, not a savings-building product,” says Greg McBride, CFA, Bankrate’s chief financial analyst. “If the goal is to build savings, just make regular deposits into a savings account rather than making loan payments.”

Building credit as you save

Having good credit is necessary to qualify for the best car loan and mortgage rates. But in the process of building credit, you usually end up spending money.

You might use a credit card, for example, to buy groceries and show lenders you can use credit responsibly. But if you’re not careful, you could waste money on interest for overdue payments. You can come across the same issue when taking out other types of loans. Making student loan payments consistently and on time can help you improve your credit score. But interest continues to add up, leaving you spending more money than you borrowed in the first place.

Credit-builder loans, on the other hand, require you to not only make payments (and pay interest) but to save money as well. When everything is paid off, you’ll receive a payment equal to the amount you borrowed (plus interest in some cases).

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Credit-builder loans vs. secured credit cards

A credit-builder loan can be a good option for someone who can’t qualify for a traditional credit card. It’s considered an installment loan for credit reporting purposes (under the FICO scoring model). And as you make payments, the credit bureaus are notified, helping you potentially boost your credit score.

A secured credit card is also designed to help consumers build credit. These cards, however, require an upfront deposit. This becomes your credit limit, establishing the maximum amount you can spend with your card. If you fail to make payments, your credit card issuer can keep some of the money from your original deposit. Otherwise, you’ll constantly have access to revolving credit that you can use to spend on different items.

With a credit-builder loan, the lender (your credit union or bank) puts money into a savings account on your behalf. The money isn’t yours until you’ve paid off the loan, leaving you with an account full of savings at the end of your term.

Someone trying to build credit could use a credit-builder loan in conjunction with a secured credit card, says personal finance and credit card expert Beverly Harzog. Another option, she says, is to have a credit-builder loan and be an authorized user on a parent’s credit card account.

Potential pitfalls

As with any financial product, its important to know what you’re signing up for. There may be fees involved with applying for a credit-builder loan, reducing the amount of money you end up saving. You can also ruin your chances of using the product to get access to better rates if you struggle to keep up with the monthly payments.

“You need to be sure that you have positive cash flow and that you can make these payments on time,” Harzog says. “Because if you don’t, that doesn’t look right. You’re not building credit.”

Pay close attention to all the terms and conditions associated with the loan. Note the interest rate and ask plenty of questions.

If you have a lot of debt and you’re not sure a credit-builder loan is something you can take on, consider talking to a credit counselor instead, Harzog adds, who can meet with you for free and offer advice.

Qualifying for a credit-builder loan could be difficult if you don’t live in a particular area or qualify for membership at a particular credit union. An alternative is the Credit Strong account, a standalone, product offered by Austin Capital Bank that’s available in most states. Borrowers who take out an installment loan and pay it off can build savings of as much as $1,000 in 12 months or $2,000 in 24 months.

Building an adequate savings cushion

Credit-builder loans help borrowers get into the habit of regularly making payments and in the end leave them with some savings. But they’re not ideal in the long run for consumers hoping to grow their emergency savings fund or set aside money for a major purchase, like a home.

Taking on additional debt just to save money is risky. A better approach would be to automate your savings. That way, you’re guaranteed to have savings after every pay period. There are games that can help you build savings and budgeting tools that can help you make adjustments in order to spend less and put away more money. Even a product like a CD could be helpful if your biggest issue is the temptation to dip into your savings account or overspend.

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