What is a Credit-Builder Loan? And How Do They Work?

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Updated: 3rd Sep 2021
Written by Jordan Blansit
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September 3, 2021
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Establishing credit is often a Catch-22.

To open a new credit account, lenders usually want to see a history of responsible credit use, as individuals with high credit scores pose less risk. But to establish said history, you need a new credit account to use credit.

Credit builder loans provide a way out of this circular logic trap. These loans offer people with no credit, thin credit files, and even bad credit an opportunity to build their score.

In turn, this may lower future interest rates, boost approval rates, and make borrowing money a more pleasant experience overall.

But, just like any other debt, credit builder loans come at a cost.

Snapshot: Credit-Builder Loan Pros and Cons

Pros:

  • Easy to qualify for
  • Many lenders report to all three credit bureaus to boost your score
  • Receive a lump sum of cash at the end of your term
  • Some loans earn interest

Cons:

  • Late or missed payments can negatively impact your credit
  • Many credit builder loans come with additional fees on top of interest
  • Not all credit builder loan lenders are reputable – do your research!

What is a Credit-Builder Loan?

A credit builder loan is a unique debt specifically designed to boost your credit score at little risk to the lender.

Many smaller financial institutions and local banks offer these loans, though some services exist primarily to provide credit-building opportunities.

You don’t need a good credit score to receive approval for a credit builder – in fact, lenders count on you not having a good score. But you do need to prove you have the income to make the payments.

How Do Credit-Builder Loans Work?

To get started, you should approach a credit builder loan like any other debt: with research and preparation.

Seek out lenders that offer rates, terms, and fees within your limits. Then, fill out a loan application with the lender that meets your needs.

Once you’re approved, the creditor will lend you a set sum – usually $1,000 or less – and deposit the funds into an account they control.

Then, you make regular monthly payments for your contract term, which can range from a few months or over two years.

During this time, the creditor will report your payments to the three major credit bureaus to build your history.

Once you pay for your loan in full, the lender will give you the funds to keep. If the loan was held in an interest-bearing savings account or certificate of deposit, you’ll receive any interest earned as well.

Some lenders may even refund a portion of the interest you paid to them upon completing your contract.

By not handing you money until after you’ve paid off your loan, credit builder lender ensures their capital remains safe until you fulfill your obligation. In return, your credit score rises as you establish a solid history with the bureaus.

How to Choose a Credit-Builder Loan: Factors to Consider

Before you run out to get a loan, you need to know what to watch out for.

APR

Your APR, or annual percentage rate, is the cost your lender charges for you to borrow funds, including interest and fees.

Most credit builder loans carry an APR between 5-10%, though some may charge up to 16%.

Loan Size

The typical size for a credit builder loan is $300 to $1,000. Remember that the size of your loan affects your monthly payment and total loan term – and may even contribute to your interest rate.

Monthly Payment

Your monthly payments vary based on how much you borrow, your loan term, and your APR.

The larger the loan and the shorter the term, the more you’ll pay every month.

Lender Reputation

As a rule, you shouldn’t take loans from shady lenders with questionable histories. If a lender has excessive complaints or poor ratings from past consumers, you may reassess whether they’re worth the risk.

Other Fees

Some lenders charge extra fees on top of their interest rates, including application, origination, late, and even membership fees. Each of these adds to the total cost of your loan.

Where Can I Find a Credit-Builder Loan?

You can access credit builder loans from multiple sources – but some are more credible than others.

Credit Unions

Credit unions are often an excellent source of personalized service and affordable financial products, including low-interest credit builder loans.

Bear in mind that you may have to fulfill a membership requirement such as living in a particular location, working in a specific career or for a named organization, or making a donation.

Local Banks

Local banks are another provider of credit builder loans. Plus, many community banks have better service, rates, or terms than their national counterparts.

Online Lenders

Dozens of online lenders also offer credit builder loans, though not all maintain licenses in every state.

Additionally, online lenders may be subject to less scrutiny, which means you should always check their:

  • Consumer ratings
  • Complaints
  • Payment terms
  • APR
  • And any fine print that may trip you up

Financial Technology Companies

Some financial technology companies, such as MoneyLion, specialize in credit builder loans.

However, they may charge membership or other fees on top of the loan’s interest rate and built-in fees. Depending on the service, that may substantially add to the cost of the loan.

Community Development Financial Institutions

CDFIs are organizations that help lower-income communities’ access essential financial products and services.

However, they may be harder to find than banks and online lenders.

Lending Circles

Lender circle programs help groups of family or friends build their credit together. Participants receive an interest-free “social loan,” with each member contributing a set amount each month. Like CDFIs, you’ll have to do your research to seek out lending circles.

Tips for Managing a Credit-Builder Loan

As with any loan, it’s crucial to understand what you’re getting into before you sign the dotted line.

#1. Choose the Right Lender

The first step is to choose the right lender based on factors that suit your situation. Look for:

  • Creditors with good reputations
  • Payments you can afford
  • Reasonable fees and interest rates
  • Terms that work within your timeframe
  • Lenders that report to all three major credit bureaus (TransUnion, Equifax, and Experian)

You might also seek lenders that stash your money in an interest-bearing account or refund a portion of your interest paid, as these lower the cost of your loan.

#2. Account for Costs and Interest Rates

Depending on the lender, you may also run into various fees – such as setup or origination fees, late payment fees, or other costs – on top of interest rates.

Every fee you pay diminishes your spending power at the end of the loan period, so watch out for excessive or high-cost fees.

Additionally, some services, such as MoneyLion, charge a membership fee on top of the loan. While this decreases the risk on their end, it increases the cost on yours.

#3. Make On-Time Monthly Payments

Once you have the loan in hand (or in-account, as the case may be), making on-time payments is key to successfully building your credit.

Remember that your lender’s job is to report your performance faithfully – not build your credit for you.

In other words, any late or missed payments will show up on your credit report alongside your on-time payments.

#4. Review Your Credit Score

The purpose of credit building loans is to build credit. As such, you should monitor your credit before, during, and after you take out a loan.

You can check your credit report for free once a year from all three bureaus. Alternatively, you can use a banking or credit app like Credit Karma to run a soft check on your credit score anytime.

#5. Create an Emergency Fund

Once you receive your funds, it’s time to decide what to do with them. But instead of blowing your cash on a vacation or new pool, consider pretending you don’t have the money at all.

Instead, use it to create a new emergency fund. Whether you choose a lower-risk investment opportunity such as a certificate of deposit or a high-yield savings bank account, sticking the money where it can grow and serve as a bulwark for emergencies may save your credit score down the line.

How Much Does a Credit-Builder Loan Cost?

Credit builder loan costs vary by lender. Consider factors such as the APR, interest payments, additional fees, and the loan limit itself.

Does a Credit-Builder Loan Help Your Credit Score?

That depends on you.

If you make your payments on time and in full, a credit builder loan may boost your score up to 60 points in a few months.

By contrast, if you make late or incomplete payments, you may damage your credit score in the long run.

Additionally, bear in mind that if you have a low credit score, rather than no credit score, you may see less benefit than someone starting with a blank slate.

Are Credit-Builder Loans Safe to Use?

Typically speaking, credit builder loans are safe as long as you source them from reputable lenders.

That said, if you don’t make your payments, you may do more harm than good regardless of the lender’s reputation.

Alternatives to Credit-Builder Loans

If you need to boost your score but aren’t sure about credit-builder loans, you have other options.

#1. Secured Credit Cards

Secured credit cards work like a credit builder loan in reverse. Instead of paying down a loan from a lender, you hand a creditor a deposit – usually $50 to $500 – and receive a credit card limit in return. (The limit is usually, but not always, equal to your deposit amount.)

Then, you use your credit card as needed and repay your bill (or at least the minimum payment) every month.

Over time, you build your credit score at no risk to the lender since they can cover any losses with your deposit amount.

Moreover, many lenders let you graduate to a traditional card after establishing a history of consistent payments. But there’s a catch: some secured credit cards charge up to 25% APR to use your own money.

#2. Credit Building Credit Cards

Some unsecured credit cards, such as student cards or those with high interest rates, don’t require a credit history to start.

But with these cards, it’s best to buy only your essentials and pay off your bill in full every month. Check out First Progress Credit Cards or the Self Visa® Credit Card.

#3. Become an Authorized User

Becoming an authorized user on a family member or friend’s account can also build your credit, though sometimes more slowly than other methods.

It’s simple: you receive a card in your name on their credit accounts. Then, their credit history is added to your credit report.

Authorized user arrangements are particularly advantageous because the user doesn’t have to give you the card at all.

They can tuck it away safely and use their credit line as usual, with you reaping benefits along the way.

#4. Unsecured Personal Loans

Unsecured personal loans also help build credit, though those with no or poor credit may find themselves paying up to 36% APR on top of excessive fees.

Additionally, not all personal loan lenders report payments to the credit bureaus, defeating the purpose of building credit.

#5. Secured Personal Loans

Secured personal loans are usually a lower-interest alternative to unsecured loans. That said, you have to put up something of value – such as your car, house, or jewelry – for the lender to sell if you default.

Are Credit Builder Loans Worth It?

Credit builder loans can be worth the cost if you’re starting from scratch or trying to rebuild your history. That said, the specific lender, your term, and the loan’s APR make all the difference. With a reputable lender that charges low fees and interest, or even repays some interest at the end, you can cheaply and safely boost your score. But with a shady lender that reports to only one bureau or charges unaffordable fees, you may find your score even worse off than before.

Bottom Line: What is a Credit-Builder Loan?

Credit builder loans are a helpful tool for those with blank slates to build their credit from scratch if you find the right lender.

Not to mention, having a hefty chunk of change at the end of the term can be a great way to set up your emergency fund in one move.

Higher credit scores mean you qualify for better interest rates and bigger loans in the future. You may even find it opens opportunities to higher-paying jobs or nicer apartments, too.

The key is to do your research, understand the terms and rates – and above all, avoid making late payments.

Jordan Blansit
Jordan Blansit
Jordan is a freelance writer with an inexplicable predilection for investing and personal finance. When she’s not click-clacketing from the comfort of her living room, you can find her (or not) craftily avoiding human contact in the California redwoods or Oregon Siskiyous with her black cat, Bean.