Do Secured Loans Build Credit & How Do They Work?

For individuals seeking to establish or improve their financial standing, understanding the role of secured loans can be a valuable step. Secured loans offer a structured way to demonstrate responsible financial behavior, which is a fundamental aspect of credit building. This process involves a lender requiring collateral to secure the loan, thereby reducing their risk and often making these loans accessible to those with limited or no credit history.

What Are Secured Loans

A secured loan is a type of borrowing arrangement where the borrower pledges an asset as collateral. This collateral serves as security for the lender, meaning if the borrower fails to repay the loan, the lender has the right to seize the asset to recover their funds. This fundamental difference sets secured loans apart from unsecured loans, which do not require any collateral and are issued based solely on a borrower’s creditworthiness and income.

Common examples of secured loans include secured credit cards and credit builder loans. A secured credit card requires a cash deposit, typically ranging from $49 to $300, which usually becomes the credit limit for the card. Borrowers then use the card like a regular credit card, making purchases and monthly payments.

Conversely, a credit builder loan operates differently, as the borrower does not receive the loan funds upfront. Instead, the loan amount, often between $300 and $1,000, is placed into a locked savings account or a certificate of deposit (CD). The borrower then makes regular payments on the loan over a set period, commonly 6 to 24 months. Once the loan is fully repaid, the borrower gains access to the funds in the savings account.

Understanding Credit Building Principles

Building a strong credit profile hinges on how financial behavior is recorded and assessed. This information is compiled into credit reports by three major nationwide credit reporting agencies: Equifax, Experian, and TransUnion. Lenders and creditors regularly send account information to these bureaus, which then use this data to generate a credit report for each consumer. These reports detail a consumer’s credit history, including types of accounts, payment status, and amounts owed.

The information within these credit reports is then used to calculate credit scores, such as the FICO Score, which is a three-digit number representing a consumer’s credit risk. Several factors influence this score:
Payment history: Accounts for approximately 35% of the score, assessing whether bills are paid on time.
Amounts owed (credit utilization): Constitutes about 30% of the score, measuring the proportion of available credit being used. A lower utilization rate, ideally below 30% of the total credit limit, is viewed favorably.
Length of credit history: Contributes around 15%, favoring older accounts and a longer track record of responsible borrowing.
New credit: Makes up about 10% of the score, as numerous new accounts in a short period can signal higher risk.
Credit mix: Accounts for approximately 10%, considering the variety of credit accounts, such as installment loans and revolving credit.

How Secured Loans Contribute to Credit

Secured loans directly impact credit profiles by influencing the core factors that determine credit scores. The primary contribution comes from establishing a positive payment history. When borrowers make consistent, on-time monthly payments on a secured credit card or a credit builder loan, this responsible behavior is reported to the credit bureaus. Timely payments can significantly improve creditworthiness over time.

For secured credit cards, managing the credit utilization ratio is another area where a positive impact can be made. The credit limit on a secured card is typically equal to the security deposit. By keeping balances low relative to this limit, ideally below 30%, cardholders demonstrate prudent credit management, which positively affects the amounts owed component of their credit score. This practice signals to lenders that the borrower is not over-reliant on available credit.

The length of credit history also benefits from secured loans. Opening a secured account and maintaining it for an extended period contributes to the average age of a person’s credit accounts. Furthermore, secured loans can improve the credit mix by adding a new type of account, whether it’s a revolving account (secured credit card) or an installment loan (credit builder loan).

Selecting a Secured Loan

Choosing an appropriate secured loan requires careful consideration to ensure it effectively supports credit building goals. A primary factor to verify is whether the lender reports account activity to all three major credit bureaus: Equifax, Experian, and TransUnion. Consistent reporting to these bureaus maximizes the impact of responsible financial behavior on a credit profile. Without reporting, the efforts to build credit through the secured loan may not be recognized.

Prospective borrowers should review the fees associated with secured loans. Secured credit cards may carry annual fees, which can range from $0 to potentially $50. Credit builder loans might have application fees, typically between $10 and $25, along with other potential charges like origination or late fees. Understanding these costs helps assess the true expense of the loan.

Interest rates are another important aspect to consider. Secured credit cards generally have variable Annual Percentage Rates (APRs) for purchases, often ranging from 25% to 30%. Credit builder loan APRs can vary widely, from as low as 5% to as high as 36%, with credit unions sometimes offering lower rates. While the goal is credit building, a high interest rate can increase the overall cost of the loan if a balance is carried or if the loan term is longer.

For secured credit cards, understanding the minimum deposit requirement is crucial, as this typically sets the initial credit limit. Some cards may allow for a higher deposit to obtain a larger credit limit, which can be beneficial for managing credit utilization. Finally, inquire about a “graduation” path, which refers to the process by which the secured card can convert to an unsecured card, often after 6 to 18 months of responsible use. This allows for the return of the security deposit while retaining the account, further aiding in credit history length.