If you have minimal or poor credit history, you may have trouble qualifying for financial products, like a mortgage or an auto loan, without a cosigner. And if you’re approved, a lender will likely charge you a higher interest rate than someone with a good credit history.
A credit-builder loan can be one way to improve your credit standing so that you’ll be able to qualify for better rates and terms in the future. Good credit can make it easier to qualify for products like credit cards and personal loans.
Keep reading to learn more about credit-builder loans, how they work and some other options to consider if you’re working on your credit.
- What is a credit-builder loan?
- How does a credit-builder loan work?
- Pros and cons of credit-builder loans
- How much will a credit-builder loan cost me?
- How much can I borrow with a credit-builder loan?
- Where can I find a credit-builder loan?
- Need to build credit? Alternatives to credit-builder loans
A credit-builder loan is a type of personal loan designed to help you establish or rebuild credit. Unlike a standard personal loan, a lender doesn’t issue you a lump sum of money upfront, which you then repay with interest over time. Instead, the lender deposits the loan amount into a secured account and releases the funds to you after you’ve made payments.
The lender reports your payments to the credit bureaus. So if you have no credit history or a low credit score, a credit-builder loan can help you build credit — as long as you make payments on time and as agreed. But the impact a credit-builder loan will have on your credit score varies.
For example, a 2020 Consumer Financial Protection Bureau study found that study participants who didn’t have existing debt saw their credit scores rise by 60 points more than participants who had existing debt.
If you’re approved for a credit-builder loan, a lender will deposit the loan amount into a locked savings or certificate of deposit (CD) account. Afterward, you’re required to make monthly payments over a repayment term that typically lasts from six to 24 months. As you repay the loan, the lender reports your payment activity to the credit bureaus.
Although loan terms vary, your loan amount is usually deposited into your savings account in small increments after you make each payment or at the end of your repayment term, minus interest and fees.
Like all financial products, a credit-builder loan has advantages and disadvantages. Before applying for one, weigh the pros against the cons.
- Easier to qualify for than a traditional personal loan — If you have minimal credit or poor credit, a lender may still approve you.
- Making on-time payments could improve your credit — A lender reports your payment activity to the three major credit bureaus — Equifax, Experian and TransUnion. If you repay your loan as promised, it’ll add positive payment history to your credit reports, potentially raising your credit score.
- Could help you build your savings — Once you repay the loan, you’ll get your money back, minus interest and fees. Afterward, you can deposit the funds into a savings account or use them as you wish.
- Interest and fees — Similar to a traditional personal loan, you have to pay interest (and sometimes fees) when you take out a credit-builder loan.
- Making a late payment could lower your credit score — If your monthly payment becomes 30 days past due, a lender can report it to the three major credit bureaus. As a result, this could lower your credit score, making it harder for you to qualify for future loans.
- Could make it harder for you to keep up with your current debt — Taking out an additional loan means you have to make additional monthly payments (if you have existing debt). As a result, you may find it more difficult to stay on top of your current debt repayment.
Your total costs will depend largely on the lender since interest rates, loan amounts offered and repayment terms vary. The higher your loan amount and interest rate are, the more expensive your loan will be.
Some lenders also charge an upfront administrative fee for processing the loan.
To get a better idea of how much a credit-builder loan might cost you, look at the annual percentage rate (APR) a lender charges, which is a measurement that accounts for interest, plus any fees.
Credit-builder loans are designed to help you establish a positive credit history, and not necessarily to pay for a big expense or purchase. While some personal loans can be for tens of thousands of dollars, credit-builder loans are generally for relatively small amounts — a few hundred to a few thousand dollars.
It’s typically a good idea not to borrow more than you actually need. Since the point of a credit-builder loan is to establish a good payment history, the amount you borrow isn’t as important as making your payments on time, as agreed. A loan for $300 could be as beneficial as a loan for $1,000. But keep in mind that a lower loan amount will mean lower monthly payments.
In fact, depending on your interest rate and how much you borrow, a credit-builder loan could come with monthly payment amounts of less than $100.
Multiple types of lenders offer credit builder loans, including:
- Credit unions — Because credit unions are not-for-profit institutions, they often offer lower interest rates and better terms. But you’ll need to meet membership qualifications, and join the credit union, to get a loan from one.
- Banks — Most large banks don’t offer credit-builder loans, but some local and community banks may offer them.
- Community Development Financial Institutions — These financial institutions focus on serving people with lower incomes who’ve historically had fewer banking options.
- Online lenders — Online lenders typically offer digital application and approval processes for credit products. And because they don’t have the expenses associated with brick-and-mortar locations, online lenders often offer competitive rates and terms.
Before you apply for a credit-builder loan, remember to research the lender to make sure it’s legit. This will minimize your chances of falling for a credit scam. And compare loans among multiple lenders to help ensure you get the best deal available to you.
If you’d like to improve your credit but don’t think a credit-builder loan is right for you, consider these alternative options:
- Become an authorized user on someone else’s credit card — Do you have a family member who uses a credit card and has good credit? You can ask them to add you as an authorized user on their oldest credit card. If the credit card issuer reports secondary users to the credit bureaus, it could help you build your credit.
- Secured credit card — A secured credit card is similar to a credit-builder loan in that it’s also designed to help you build credit. Unlike a traditional credit card, with a secured credit card the issuer requires a security deposit, which acts as collateral and helps establish your credit limit. If you pay your credit card bill on time and the credit card issuer reports this information to the credit bureaus, it could help build a positive credit history.
- Secured personal loan — You may find it easier to qualify for a secured personal loan if you have bad credit since it’s less risky for the lender. This option requires you to pledge collateral — something of value the lender can seize, like a bank account or car title — if you fail to repay the loan.
- Traditional credit card — If you have bad credit, you may also qualify for an unsecured credit card. With this option, you may face a higher APR. To avoid interest, though, you can pay your credit card bill in full on or before the due date.