What Is a Credit Builder Loan?
A credit builder loan is one way to build or rebuild credit history. Credit builder loans can have both pros and cons, and it's helpful to know what they can or can't do for you.
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A credit builder loan is designed to help you establish or build a positive credit history. Instead of getting the money you borrow upfront, you pay the lender first. Once you have paid the loan in full, the proceeds are turned over to you.
Credit builder loans can be a good way to rebuild credit or build it for the first time. However, they’re not necessarily right for everyone and there are some pros and cons to keep in mind.
Understanding how a credit builder loan works and what it can—or can’t—do for you can help you decide if applying for one makes sense.
In this guide:
- How do credit builder loans work?
- What does a credit builder loan do?
- How much does a credit builder loan cost?
- Who are credit builder loans best for?
- Are credit builder loans worth it?
- How to get a credit builder loan
How do credit builder loans work?
Credit builder loans are unique in terms of the way they work. The exact process varies by lender, but here’s what you can typically expect to happen if you’re approved for one of these loans.
- You take out the loan. A lender approves a loan amount but doesn’t issue funds. Instead, an interest-bearing account, such as a certificate of deposit (CD), savings account, or money market account, is opened for you. This is similar to a savings plan while also building or repairing your credit.
- You begin repaying the loan. Repayment on credit builder loans typically starts immediately according to the lender’s payment schedule. As you make payments, your money is parked in the account the lender opened for your loan.
- The lender reports your payments to the credit bureaus. Your payments are reported to the three major credit bureaus—Equifax, Experian, and TransUnion. This shows payment history on your credit report, thus improving your credit score.
- You get the funds once the loan is paid in full. After you repay the full loan amount, the lender releases the money to you after deducting any applicable interest and fees.
Credit builder loans are usually for small amounts and have shorter repayment terms. You might borrow $1,000 and pay it back over 12 to 36 months. That reflects the goal of these loans—it’s less about the funds you receive and more about building credit. It’s important to keep this goal in mind.
How does a credit builder loan compare to a traditional loan?
When you get a personal loan, you receive a lump sum that you can use for just about any purpose. You might use a personal loan to consolidate debt or pay for home renovations, for example. You’d then pay the loan back to the lender, along with applicable interest and fees.
Credit builder loans don’t work that way since you’re not getting any money upfront. That’s the biggest difference between credit builder loans and traditional personal loans. However, there are other attributes that set them apart.
| Credit builder loans | Traditional personal loans | |
| Loan limits | Typically small; $1,000 is a common loan amount | Typically higher; some lenders offer up to $100,000 |
| Repayment terms | May extend from 6 – 36 months before receiving loan funds | May extend up to 84 months after receiving funds, depending on the lender |
| Interest and fees | Lenders can charge interest, late fees, and administrative fees | Lenders can charge interest, late fees, origination fees, and prepayment penalties |
| Credit requirements | Some lenders may approve borrowers without a hard credit check | A hard credit check is typically required to get approved |
| Suitable for | Building credit history | Debt consolidation, large purchases, emergency expenses |
What does a credit builder loan do?
Credit builder loans are designed to help you build or rebuild credit. They’re not intended to provide cash for emergencies or help you pay for large expenses. A credit builder loan’s primary goal is to help you improve your credit score.
A secondary goal is to help you grow some savings. While having money saved in the bank won’t affect your credit score, it could make you less likely to borrow when you need cash.
How does a credit builder loan help your credit score?
A credit builder loan can help you build or rebuild credit because it allows you to establish a history of on-time payments. Why is that important? Because payment history carries the most weight in FICO credit scoring.
Many lenders use FICO scores to gauge how responsibly you use credit and manage money. Here’s how the score breakdown works:
- Payment history: 35% of your score
- Credit utilization: 30% of your score
- Credit age: 15% of your score
- Credit inquiries: 10% of your score
- Credit mix: 10% of your score
Paying on time is one of the most effective ways to build a good credit history. Credit builder loans allow you to establish a payment history by making monthly payments to a lender.
There is a flip side, however. Paying a credit builder loan late or not paying at all could seriously damage your credit score.
How much can a credit builder loan raise your credit score? The score improvements aren’t uniform. A study from the Consumer Financial Protection Bureau found that:
- Taking out a credit builder loan increased a borrower’s likelihood of having a credit score by 24% if they had no existing debt. Most participants with existing debt already had a credit score, so a credit builder loan had less of an impact in establishing a credit score for those borrowers.
- Borrowers without existing debt saw their credit scores increase by 60 points more than borrowers who had debt prior to getting a credit builder loan.
Bottom line? A credit builder loan can be particularly effective for establishing a credit score if you have zero credit history. It can also boost your credit score if you pay on time, but the number of points added can depend on whether you already have a credit history.
How does it help build savings?
A credit builder loan is essentially a forced savings plan because the loan funds aren’t paid out to you right away.
Instead, the lender puts the money into an escrow account until the loan is paid in full. Once the money is released, you could use it to start building an emergency fund or save for another financial goal.
That aspect of credit builder loans is a nice benefit for people who may have struggled with getting into a savings habit. You could keep it going by putting the money into a new savings account, then continuing to deposit the same amount each month that you were paying to the lender.
How much does a credit builder loan cost?
Credit builder loans can charge fees and interest, though what you’ll pay can vary from lender to lender.
The main costs to know with credit builder loans include:
- Administrative fees
- Annual fees
- Late fees
- Annual percentage rate (APR)
An administrative fee is usually a one-time fee that you pay, similar to an origination fee for a traditional personal loan. Annual fees are similar to the annual fee you might pay for a credit card.
Some of the best credit builder loans are free of administrative or annual fees, but you can expect to pay late payment fees and APR on your loan amount before it is issued to you at the end of your payment term. Fees and APR cover the cost for service to help build your credit.
APR rates on a credit builder loan are usually fixed. You might find credit builder loans with an APR as low as 5% while others may charge closer to 16%. Calculating what you’ll pay in interest and fees can help you understand what you’ll walk away with once the loan is repaid.
For example, say that you get a medium builder loan from Self. You pay a $9 administrative fee and make total payments of $840 over 24 months. Assuming an APR of 15.97%, you’d get back $724 at the end of the loan term for a final cost of $125.
Who are credit builder loans best for?
Credit builder loans are generally suited for people hoping to build credit for the first time. As noted by the CFPB’s research, people who took out a credit builder loan without existing debt were more likely to see the biggest improvements in their credit scores.
If you already have some credit history, even if it’s poor, you might be better off pursuing a different route to rebuilding credit. For example, you might consider:
- Applying for a secured credit card
- Asking someone to add you to one of their credit cards as an authorized user
- Getting a personal loan
Secured credit cards require a cash deposit to open, which doubles as your credit limit. You may be able to get that deposit back and convert it to an unsecured credit card after making a certain number of on-time payments. Some secured credit cards even earn cash back or points on purchases.
Becoming an authorized user allows you to use someone else’s credit card and piggyback off their good credit history without being liable for any debt associated with the card. That can be a backdoor way to rebuild credit if you have someone willing to add you to one of their cards.
Personal loans can be secured or unsecured, and they can provide you with a lump sum of cash for different needs. It’s possible to find personal loans for people with bad credit that you could use to rebuild your credit history. Just keep in mind that you might pay higher rates for those loans.
Are credit builder loans worth it?
Credit builder loans have pros and cons, and whether it makes sense to get one depends on your situation.
On the pro side, you could use a credit builder loan to improve your credit score and build some savings simultaneously. Monthly payments are usually low since you’re not borrowing a large amount, and it’s possible to find credit builder loans with relatively low interest rates.
Are credit builder loans the best way to establish or rebuild credit? It truly depends on the individual’s circumstance. For some, the answer may be no. Considering what you’ll pay in fees and interest and how much your score could improve can help you decide if you should get a credit builder loan.
How to get a credit builder loan
If you’re interested in getting a credit builder loan, it helps to know where you can find them and what you’ll need to apply. Credit builder loans typically aren’t as widely available as traditional loans. The requirements for getting one can vary from lender to lender.
Where can you get a credit builder loan?
There are a few different options for getting credit builder loans, each with advantages and disadvantages. If you’re looking for credit builder loans, you might try:
- Online lenders. Online lenders like Self and Cheese can offer credit builder loans to eligible borrowers. Keep in mind that some online lenders may only offer loans in some states.
- Credit unions. A credit union is a member-owned financial institution that offers products and services similar to what you might find at a bank. Credit unions can provide credit builder loans and share-secured loans, which are secured by a share certificate. That’s the credit union equivalent of a CD account. Keep in mind there may be a membership requirement.
- Community Development Financial Institutions (CDFIs). CDFIs operate in local communities to help provide businesses and individuals with loans for different needs. You can look for a CDFI near you to see if any offer credit builder loans.
- Lending circles. Lending circles can provide loans to people with limited credit history and help them build credit as they repay. Instead of coming from a lender, loans are funded by members of the circle. Each member of the circle has an opportunity to borrow money.
Out of these options, an online lender might offer the easiest path to approval for a credit builder loan. Credit unions typically have membership requirements you need to meet to join.
Meanwhile, CDFIs may limit lending to members of certain demographic groups, such as underserved populations or low-income households. Lending circles may require you to complete financial education courses or meet other conditions before receiving a loan.
What do you need to apply?
Individual lenders can determine what you’ll need to apply for a credit builder loan, but at a minimum, you’ll need to provide some basic information. That includes your:
- Name
- Address
- Phone number
- Date of birth
- Social Security number
- Driver’s license or government ID number
- Monthly or annual income
- Employment status
- Monthly housing payment
Whether or not a hard credit check is required is up to the lender. Some credit builder loans require them, others don’t. Keep in mind that if a hard credit pull is necessary, that can knock a few points off your credit score.
You generally need to be at least 18 to apply for a credit builder loan, and you may need to be a U.S. citizen or permanent resident. The lender may also ask you to verify that you have a bank account or prepaid debit card account that you’ll use to make loan payments.
Once approved, you may need to pay the administrative fee upfront if there is one. The lender will establish the escrow account and you’ll start making payments.
Remember that this is a debt, even though you’re not getting any money upfront, and you’ll still need to pay back what you borrow to avoid credit score damage.
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