What You Need To Know About Credit-Builder Loans

What Is a Credit-Builder Loan?

A credit-builder loan is a special loan some financial institutions offer to help borrowers with low credit scores to improve their score or to help borrowers get on the map with a credit score if they haven't had credit before. Credit unions and community banks are the most likely to offer these types of loans, though you may not see them widely advertised!

How Do Credit-Builder Loans Work?

Credit-builder loans are secured loans backed with the borrower’s own money. Once the bank approves your loan, it will deposit your money into a bank account, money market mutual fund, or certificate of deposit (CD). You can then essentially borrow your own money.

For example, let’s say you get a credit-builder loan for $2,000. You pay the $2,000 to the lender who puts it into a secured account. You can then begin borrowing it from the lender. You will make monthly payments on the principal and interest of the debt—the amount you borrowed— until you repay it in full. Then the lender will refund the loan amount. Credit-builder loans usually have a term from six months to two years. Loan amounts range from $300 to $2,000 or more. 

Because the loans are backed up by your cash, they loans aren't very risky for lenders. If you miss payments or default on the loan, the lender can use the money they’re holding to cover the balance due. This means if you can still be approved for this kind of loan even if you have no credit or bad credit.

How Does This Help Me Build My Credit?

As you repay your loan each month, your payments will be reported to one or more of the major credit bureaus— Experian, TransUnion, and Equifax. These count just like any other loan or credit card payment on your credit history. Since on-time payments are an important factor in determining your credit score, this is the main power of the credit-builder loan. Making payments on time each month shows future lenders that you are a trustworthy candidate for a loan. It also helps you build a credit history, which is the backbone of your credit report.

Over time, these payments help boost your credit score. Plus, at the end of the loan term, you’ll get your loan balance back.

Bonus! Credit-builder loans also act as a form of savings account. 

What Are the Disadvantages of Credit-Builder Loans?

Credit-builder loans are great, but there are some disadvantages. For one, you have to come up with the loan balance upfront. If you don't already have at least a small savings or you're struggling with your finances, this may be difficult. Second, you won’t have access to the loan proceeds until you’ve fully repaid the loan.

If you can clear these hurdles, you can start to rebuild your credit and improve your personal finances. If you can't, you may look into becoming an authorized user on someone else's credit card. Learn more about that and other ideas in our article 12 Ways To Build a Strong Credit History.  

Will It Really Improve My Credit Score?

About one-third of your credit score is based on your payment history. If you can stay current on your loan (and other monthly) payments , then your score will eventually start to improve. So, yes, credit-builder loans can be an excellent way to rebuild your credit score over time!

If you start making late payments or miss payments on your credit-builder loan, you will hurt your credit score. That's why it's best no to take out one of these loans if you aren’t certain that you can make the monthly payments. Remember, you can always start with a small loan and small monthly payment that is affordable for you.

What Should I Look for When Shopping for a Credit-Builder Loan?

Here is a quick list of questions to ask when shopping for a credit-builder loan:

• What is the APR (annual percentage rate) or interest rate?

  • APRs for credit-builder loans can range from 10%-15%. be prepared to pay a higher interest rate at the outset, but shop around and compare rates. Also keep in mind that these terms will always be more generous than terms for payday loans or other forms of fast credit.

• Are there any fees?

  • Some lenders charge applications and others charge a monthly or annual fee. You should also ask if there are any early payoff/prepayment penalties or late payment fees or penalties. Ask the lender to explain any and all fees associated with the loan, so you can get a sense of the true cost of the loan.

• What will my monthly loan payment be?

  • You want to make sure you can afford your monthly payment. Usually, the loan amount (credit limit) and the term (number of months of the loan) will determine your loan payment. You can ask the lender to adjust these numbers to land at an affordable monthly payment.

• How much will this loan cost me in the long run once you include interest?

  • If the lender doesn't have this information at hand, you can use an online loan calculator/calculators/loan-calculator/ to figure out the real cost of the loan.

Be sure to look at multiple options! Ask these questions of each lender and figure out which loan will work the best for you.

What Financial Institutions Offer Credit-Builder Loans?

In most cases, regional banks, community banks, local banks, and credit unions offer credit-building loans. Some federal credit unions and other lenders looking for new business may also offer these loans, though they may charge higher interest rates. They aren't always advertised as "credit-builder loans." You may see them called "Fresh Start Loans" or something similar.

Do a Google search to find potential lenders in your state. Several different lenders will likely come up, so be sure to do your research. Check reviews and ask questions about the interest rate, repayment terms, and other options.

How Is a Credit-Builder Loan Different From a Traditional Loan?

With a traditional loan, like a personal loan, the lender gives the proceeds to the borrower upfront. The lender takes on the risk of not getting their money back if the borrower defaults on, or doesn’t repay, the loan. Credit-builder loans differ from traditional loans in that the borrower gives the lender the loan proceeds upfront. The lender then holds the loan proceeds, which the borrower can draw on or borrow from overtime.  

Credit-builder loans are less risky for lenders because the borrower has to come up with the loan collateral in cash before the loan is made. The lender keeps the collateral proceeds in an account where they can access it if it becomes necessary. For this reason, the lender is willing to loan the borrower money even though they have either no credit history or bad credit. Some lenders won’t even run a credit check on the borrower if they have enough income to make the loan payments. 

Let’s Summarize...

You can build good credit and credit-builder loans can help you get there. These are special loans available to those who have bad credit or no credit. They require you to come up with a security deposit for the loan upfront, then you’ll make payments on the balance until the loan is paid off. This helps you show a stable payment history, which improves your credit score. While these loans may come with fees and interest, they can save you money in the long run by lowering interest rates on future loans. Consult your financial advisor or a nonprofit credit counselor for more information on how you can use a credit-builder loan to improve your FICO score and credit report.