Board of Governors of the Federal Reserve System

December 06, 2024

An Overview of Credit-Building Products

Alexander Bruce and Simona M. Hannon^*

Credit-building products are secured small-dollar products that allow consumers to either establish or improve their credit scores by having lenders report their payment activity to credit bureaus. Examples include secured credit cards or loan products such as credit-builder and passbook loans. Despite the potentially significant role that credit building products could play in increasing credit access, relatively little is known about this sector empirically, as data available to researchers to study these products have been historically scarce. In this short analysis, we use a recently released detailed version of the Federal Reserve Bank of New York Consumer Credit Panel (CCP)/Equifax credit bureau data to construct measures of key credit-building products—secured credit cards and secured small-dollar loans—to bridge this data gap. In the remainder of this note, we will review the main product types in this sector and use our new data to document developments in this sector since 2010.

Main Product Types

Credit building can be achieved in a number of ways. For example, a consumer can be added as an authorized user on an account in good standing or can use cosigned credit products (Case, 2022). Alternatively, a consumer can make use of various programs that allow the addition of payment history to credit reports or that use bank account information to assess financial behavior.¹ That said, the two financial products most central to establishing or improving credit scores are secured credit cards and secured small-dollar loans, which are the focus of the analysis in this note.²

Secured credit cards are credit cards with low credit limits that require a cash deposit usually equal to the credit limit.³ The deposit is used as collateral and the payment history is reported to credit bureaus. Although they are easier to obtain than unsecured credit cards, the annual percentage rate (APR) on these cards may be higher than that on unsecured credit cards (Axelton, 2022).⁴ These products are primarily offered by large credit card providers (Santucci, 2024).

Secured small-dollar loans consist of either credit-builder loans or passbook loans.⁵ The key difference between the two secured small-dollar loan types is the ownership of the collateral at issuance, as is discussed next. Credit-builder loans are secured small-dollar products, with origination amounts typically between $300 and $1,000 that are specifically designed for credit building.⁶ They function less like a loan and more like a (costly) savings device (Burke et al., 2023). Unlike for traditional loans, when the borrower receives the money after application and makes payments to the lender, with a credit-builder loan, the lender deposits the loan amount into a savings account or certificate of deposit (CD) that is held as collateral and is controlled by the lender. The funds become available to the borrower after repayment, which includes the principal and an administrative fee (Burke et al., 2023). Lenders report payment activity to credit bureaus, thus establishing a credit history for the borrower. Credit-builder loans are typically provided by smaller depository institutions, such as credit unions and community banks.⁷

Passbook loans are secured loans with small origination amounts that are collateralized by a savings account or a CD that is owned by the borrower. They are often used for credit building, but could be used for borrowing purposes unrelated to credit building (Brozic, 2024). They allow borrowers to build credit by having lenders report their payments to credit bureaus. Given their secured nature, passbook loans tend to have lower interest rates than unsecured personal loans (Meacham, 2024). That said, because borrowers own the collateral, they end up paying interest on borrowing their own funds (Bareham, 2024). This cost may be offset to some extent by borrowers earning interest on the funds kept in savings accounts and by avoiding CD withdrawal fees. Similar to credit-builder loans, passbook loans are typically provided by smaller depository institutions— banks and credit unions—as major financial institutions do not offer them (VanSomeren, 2022).⁸

Data

For the purposes of this analysis, we define credit-building products as those secured credit cards and secured small-dollar loans with a credit limit or an origination amount of $1,000 or less issued by depository institutions—banks, thrifts, and credit unions—to borrowers without credit scores or with nonprime ones.⁹ To measure these products, similar to other studies examining small-dollar lending in the U.S.—for example, Flagg and Hannon (2024)—we base our analysis on credit card and small-dollar loan holdings reflected in the newly released tradeline-level (or account- or loan-level) version of the Federal Reserve Bank of New York CCP/Equifax data, a database on consumers' credit use and payment performance drawn from anonymized Equifax credit bureau records.¹⁰ Our CCP sample has coverage of all credit cards (up to 10 cards per borrower) and all personal loan holdings (up to 4 loans per borrower). The data also contain industry indicators and narrative codes. For credit cards, the industry indicators allow for the categorization of some of the accounts by expenditure sector, or where the cards were used, thus permitting for the elimination of retail credit accounts—see Flagg et al. (2024).¹¹ For loans, the industry indicators allow for the identification of the issuer type: depository institutions—banks, thrifts, and credit unions, and finance companies—personal loan companies, sales finance companies, and a miscellaneous finance company category. The narrative codes offer additional details about each trade, such as whether they are secured. This allows us to isolate secured accounts, which is salient for our analysis. That said, our data do not allow for the separation of credit-builder loans—that are specifically designed for establishing or improving credit—from passbook or other secured small-dollar loans.¹² As a result, we have to examine the secured small-dollar loan types together.

As small-dollar products have much lower incidence than other credit product types, to ensure proper coverage, we use the total available nationally representative 5 percent random sample, covering the period between 2010:Q1 and 2024:Q1. As of the beginning of 2024, the CCP loan-level sample showed that over 3 million individuals, or approximately 1 percent of the entire adult population covered by the CCP, had secured small-dollar products.¹³ 93 percent, or 2.8 million, of them are either without credit scores or have nonprime ones. These are the borrowers at the core of this study.

Findings

The credit-building product sector reflected in the CCP data currently stands at $845 million and consists of more than 3 million accounts, with a median origination amount of $500 and a median monthly payment of $26 (Table 1). These accounts are held by typically younger nonprime borrowers, with a median age of 36 and with a median Equifax Risk Score of 604. Borrowers under 40 and deep subprime borrowers each hold more than half of total outstanding balances.¹⁴

Table 1: Credit-Building Products Characteristics as of 2024:Q1

Looking at outstanding balances (Figure 1a) and accounts (Table 1), we note the key role historically played by secured cards within the credit-building product market. Secured cards currently cover 58 percent of balances and 76 percent of accounts, with the remainder consisting of secured small-dollar loans. The median secured card origination amount is $325, with a median monthly payment of $26, while the median secured small-dollar loan has a credit limit of $724 and a monthly payment of $35. Early in 2020, secured credit card outstanding balances (Figure 1a) and originations (Figure 1b) dropped because of a large lender's market exit in 2019, which was followed by the onset of the pandemic (Santucci, 2024). Starting in 2020, originations for both product types rose notably and remained elevated for about two years, before returning close to their pre-pandemic levels by 2024:Q1. Forthcoming analysis attributes the recent increase in credit-building products to fiscal policy effects (Hannon, forthcoming).¹⁵

Figure 1. Credit-Building Outstanding Balances and Originations, by Product Type

Next, when examining the credit-building sector through the lens of borrowers' credit risk profiles (Table 1), we note differences related to the influence of institutional characteristics on product issuance. Secured cards, typically originated by large credit card providers, as we previously mentioned, are issued to borrowers with slightly higher credit scores than secured small-dollar loans, which are usually offered by smaller lenders, such as credit unions and community banks. The median credit score on a secured credit card account is 608, while the median credit score on a secured small-dollar loan is 576. This trend is further reflected in the shares of balances of each credit-building product type held by deep subprime consumers—approximately 48 percent for secured credit cards and 54 percent for secured small-dollar loans. Looking at originations by credit score for the entire sector (Figure 2a), we note that while originations increased significantly in 2020 and 2021 for all risk groups, they grew most for deep subprime borrowers.

Figure 2. Credit-Building Originations, by Risk and Age Group

Looking at the borrowers' ages in the CCP data (Table 1), we find small differences in credit-building product holdings. Secured cards are held by borrowers with a median age of 36, while secured small-dollar loans are held by slightly younger borrowers, with a median age of 34. That said, borrowers under 40 hold different shares of each product type—55 percent of secured credit card balances and 66 percent of secured small-dollar loan balances. Looking at originations by age group across the sector (Figure 2b), we note that while originations for all age groups rose in 2020 and 2021, the majority of the increase is driven by enrollment in credit-building products by borrowers aged 25 to 39.

Finally, looking at the credit quality of these products (Table 1), we note that delinquency rates are slightly lower on secured credit card accounts, standing at 9.5 percent, and higher, at 11.2 percent, on secured small-dollar loans. That said, as shown in Figure 3, delinquency rates for both product types have been rising following the pandemic period, in line with those for other loan types.

Figure 3. Delinquency Rates, by Product Type

Credit-Building Product Usage Effects

Although credit-building products are expected to contribute to improved credit scores following consistent repayment, the effects of credit-building product usage are only partially known. Some potential downsides associated with the use of such products include borrowers not seeing established or improved credit scores because of lenders not reporting their payment activity to credit bureaus or them defaulting and losing the collateral.

The limited literature on credit-building products provides mixed results. Looking at the universe of secured credit cards reflected in Y-14M data, Santucci (2016) finds that keeping an account open for two years is associated with a 24 point increase in median credit scores.¹⁶ Closing the account because of default, however, is associated with a 60 point decrease in median risk scores. For credit-builder loans, a 2020 Consumer Financial Protection Bureau study based on data from three sources finds that, for participants without existing debt, opening a credit-builder loan increased their likelihood of having a credit score 24 percent.¹⁷ Additionally, the report shows that participants without existing debt had credit score increases of 60 points relative to their peers with debt. The study also points to a $253 increase in the participants' savings balances. That said, the report also showed results suggesting that consumers had difficulty incorporating additional payments into their obligations—consumers with existing debt saw slight decreases in their scores.¹⁸

Conclusion

In this note, we provided an overview of an understudied sector—credit-building products—using a novel version of credit bureau data. The credit-building sector currently stands at $845 million and consists of 3 million accounts held by 2.8 million individuals. From a product perspective, the sector is divided between secured credit cards, which cover nearly 60 percent of outstanding balances, and secured small-dollar loans used for credit building—credit-builder and passbook loans. From an institutional perspective, the sector is segmented between large credit card providers and smaller depository institutions. In 2020 and 2021 the sector experienced an episode of significant growth that is attributed by some studies to fiscal policy effects (Hannon, forthcoming). All credit risk groups exhibited growth, which was driven by enrollment in credit-building products by younger borrowers aged between 25 and 39.

References

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Axelton, K. (2022). "What Is a Secured Credit Card?" https://www.experian.com/blogs/ask-experian/what-is-a-secured-credit-card/. Experian's Official Credit Advice Blog, June 1.

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Meacham, J. (2024). "Passbook Loan: Meaning, How it Works, Pros and Cons," https://www.investopedia.com/terms/p/passbook-loan.asp. Investopedia, July 21.

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Santucci, L. (2024). "Secured Card Market Update (PDF)," Consumer Finance Institute Special Report. Philadelphia: Federal Reserve Bank of Philadelphia, May.

VanSomeren, L. (2022). "What Is A Passbook Loan?" https://www.forbes.com/advisor/personal-loans/passbook-loan/. Forbes Advisor, November 28.