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What is a credit-builder loan?
As the name suggests, a credit-builder loan is a unique type of loan that is specially designed to help you build your credit.
In contrast to traditional loans, when you take out a credit-builder loan, you won’t actually receive any money upfront. Instead, your lender will place the funds in a special bank account that you can’t access right away. The total size of the loan may be fairly small—credit-builder loans are often for just $300 to $1,000. 1
You’ll make regular payments (just as you would with a normal installment loan, like a car loan or mortgage) until the end of the repayment period, which will often be 6–24 months. 1
As you pay the loan down, your lender will report your monthly payments to the credit bureaus, which allows you to establish a good payment history. Once you’ve paid off the full loan amount, you’ll receive the funds.
Credit-builder loans are usually offered by small financial institutions, such as credit unions and community banks. Because your lender can reclaim the loan amount at any time if you stop making payments, credit-builder loans aren’t as risky for them as traditional loans. This makes them easier to get than many other forms of credit.
Who are credit-builder loans for?
Credit-builder loans are for anyone who wants to build credit or improve their credit score. Although just about anyone can get a credit-builder loan, they’re mainly geared toward two groups:
- People who have an insufficient credit history
- People who have a bad credit score
If you’ve only just started trying to build credit or if your credit score has dropped for some reason, then you might have noticed the catch-22 of the credit world: it’s hard to get credit without a good credit score, but it’s impossible to get a good credit score without being able to obtain credit.
Credit-builder loans can help fix this problem. They’re designed for people with poor (or no) credit. 2 Consequently, they often have minimal (or non-existent) credit score criteria, which means they’re useful if you’re in any of the following circumstances:
- You’re looking to take out your first loan
- Your credit report is “thin” (i.e., doesn’t have many items) because it’s been a few years since you last used credit
- You’re just making a start as a US resident
- You’ve gone through a financial rough patch that’s messed up your credit.
How does a credit-builder loan improve your credit score?
Credit-builder loans contribute to several factors that go into the calculation of your credit score:
- Payment history: Your payment history is a record of the payments you’ve made on your loans, credit cards, and other credit accounts. It’s the most important factor that influences your credit score. Making all your payments on time for your credit-builder loan can considerably improve your credit score, especially if your payment history is otherwise relatively thin.
- Credit mix: Your credit mix is the variety of the types of credit accounts you have. Your credit score will be higher if you have a mix of revolving credit accounts (like credit cards) and installment loans, so credit-builder loans can be particularly helpful if you otherwise would only have revolving accounts.
How does a credit-builder loan work?
Credit-builder loans work like other installment loans, with the exception that you won’t actually be able to access the money you’re borrowing until you’ve fully paid the loan off.
Opening and paying for a credit-builder loan involves the following six steps:
1. You apply for the loan
When you apply for a credit-builder loan, you’ll usually have the choice of using your lender’s website or visiting one of their brick-and-mortar locations. You might or might not have to consent to a credit check, depending on their policy. You probably will have to submit a number of documents, which may include:
- Your personal info: name, Social Security number, etc
- Contact info, including your address and phone number
- A photo ID, such as your passport or driver’s license
- Verification of your employment
- Your monthly pre-tax income, with pay stubs or tax returns to verify it
- Documentation of your other financial obligations (i.e., rent or mortgage payments)
- Your checking and savings account balances
- References for your lender to check
If that list seems overwhelming, bear in mind that not all lenders require all of those documents. It’s worth calling ahead to find out what you actually need to bring.
2. You pay an administration fee
Once you’re approved for a credit-builder loan, you may have to pay an additional fee, usually called an administration fee. The amount can vary and might be a flat fee or a percentage of the loan amount. Your payment schedule can also vary—it might be a one-time fee or something you’ll have to pay on a monthly basis.
3. Your lender opens a savings account
Your lender will then set aside the amount of the loan in a savings account for you, which you normally won’t be able to access until you finish repaying the loan in full. 1
4. You make regular payments
You’ll repay the loan in set monthly installments over a period of about 6 to 24 months. The installments depend on the size of the loan and the payment schedule you agree on with your lender.
You may also have to repay interest, which in some cases will eventually be refunded. Interest rates on credit-builder loans fall into a fairly broad range, and can be as low as 1% or as high as 16% per year. 4
5. Your lender reports your payments to the bureaus
Your lender will report your payments to the credit bureaus each month. If you consistently pay on time, your credit score will increase. On the other hand, if you fail to make your payments on time, your credit score will fall (which defeats the purpose of the loan).
6. You receive the funds
Once you’ve fully repaid your loan, your lender will give you access to the savings account holding the loan or will transfer the money into one of your existing accounts, minus any fees.
Once your loan is closed, assuming it isn’t associated with any negative information like late payments, it will stay on your Experian, Equifax, and TransUnion credit reports for up to 10 years. If you missed any payments, the negative mark associated with the late payment will remain on your credit report for 7 years. 5 6 7
Pros and cons of credit-builder loans
Like most other credit-building solutions, credit-builder loans aren’t for everyone, and they’ll help some people more than others. Take a moment to consider some of their advantages and disadvantages before looking for a lender.
What are the benefits of credit-builder loans?
Credit-builder loans have two major benefits:
- Improving your credit score: This is the main benefit of a credit-builder loan. If you leverage one successfully, you’ll eventually be able to reap all the benefits of a good credit score, including access to unsecured loans, credit cards, and other types of credit. Even if you already have a relatively good credit history, a small improvement could get you higher credit limits, lower interest rates, and better deals in general.
- Building your savings: One study found that taking out a credit-builder loan helped people to increase their savings by about $253 on average. Taking out this type of loan can be a good strategy for putting away some extra cash. 1
What are the downsides or risks of credit-builder loans?
Despite their advantages, credit-builder loans also have several potential downsides and risks:
- Risk of damaging your credit with late payments: Missing a payment on your credit-builder loan will hurt your credit rather than benefit it, so make sure the monthly payments will fit into your budget before you get started. This is particularly important if you have other debts you’re currently paying off—a study by the Consumer Financial Protection Bureau found that people who took out credit-builder loans when they had other debts (particularly from loans) were much more likely to have late payments. 1
- Potential score drop from a credit check: Before applying for a credit-builder loan, ask your prospective lender whether they’ll run a credit check. If they do, it’ll trigger a hard inquiry, which will take a few points off your credit score (usually no more than 5–10, depending on the scoring model). 8 9
- Costs associated with credit-builder loans: Credit-builder loans often have associated costs, including application fees, late fees, and interest.
- Potential income requirements: Although applying for a credit-builder loan doesn’t always require a credit check, these loans often have income requirements to ensure that you have enough money to make your payments, so you may need to provide proof of income for the past few months. 10
How much will a credit-builder loan improve my credit score?
How much a credit-builder loan will improve your score depends on several factors, including what other debts you have and what your credit score currently is.
Your existing debts
As mentioned, credit-builder loans are more likely to help your score if you’re starting out without any other debts. While results can vary considerably, the CFPB found that people who took out credit-builder loans when they had no other debt obligations saw an average score improvement of around 60 points. However, people who already had debts actually saw a small decrease in their credit scores. 1
Your current credit score
If you’re starting out with a relatively good credit score, you might not get as much benefit from a credit-builder loan, particularly in the short term. This is because opening new accounts can cause a temporary dip in your credit score by potentially triggering a hard inquiry or reducing the average age of your accounts (a factor that contributes to the length of your credit history, which is a scoring factor in the main credit scoring models).
Moreover, once your credit score reaches around 760 points, there’s a plateau in terms of the benefits you can gain from further increasing your score. 11
If your credit score is reasonably good already and you already have several open accounts, then adding new accounts might not help you that much in practice. You might be better served by focusing on keeping your existing credit cards and loans in good standing.
Where to find the best credit-builder loans
To find the best credit-builder loans, you should check with the following institutions:
Credit unions or community banks
Credit unions and community banks frequently offer credit-builder loans. You can use this credit union locator to find one in your area.
Credit unions often have membership requirements (such as living or working in a certain place, being related to an existing member, or attending a specific school or church).
However, they often offer the best credit-builder loans because they’re not-for-profit organizations. This means that all profits are reinvested back into the union to keep interest rates low.
Community development financial institutions
You can also get a credit-builder loan from a community development financial institution (CDFI). This is an organization created to support lower-income communities.
There are CDFIs in every US state, so you should be able to find a CDFI in your area.
Online lenders
You can also search for online lenders who offer credit-builder loans. However, some of these lenders aren’t licensed in every state. Check which lenders operate in your part of the country.
Online lenders charge vastly different administration fees and late fees, and they have different loan terms. You’ll need to shop around to get the best deal.
Formalized lending circles
“Lending circles” can be informal groups (usually family members or groups of friends) who decide to put money together to loan to each other. But you can also take part in a formalized lending circle program, where your payments will be reported to the credit bureaus.
A lending circle recruits a group of around 6 to 12 people who get together and decide how much they want to loan. 12
Everyone makes monthly payments (e.g., $50, $100, or $200), and every month, a different member of the group receives the loan amount. This cycle repeats until everyone has received the same amount. These loans are particularly good because they’re normally interest-free.
If you don’t know a group of people who want to form a lending circle, you can try searching for lending circles in your area.
Note that there may be requirements for some programs (e.g., regarding income or the maximum amount of debt you’re allowed to have to take part).
Alternatives to credit-builder loans
If you’re not sure that a credit-builder loan is right for you, then don’t worry. There are many other ways you can go about building your credit.
Try the following four methods:
1. Get a secured credit card
Secured credit cards are much easier to get and have lower credit score requirements than unsecured credit cards. If you have a lot of negative marks on your credit report, this can be a good way to rebuild your credit.
Like credit-builder loans, secured credit cards require an upfront deposit as “security,” and the amount you put down as a deposit is usually the card limit. Typical deposits range from around $50 to $300. 13
2. Become an authorized user
If you have a close friend or relative with an excellent credit score, consider asking them to name you as an authorized user on one of their credit cards.
The card’s account history will then be added to your credit report, which will probably boost your score thanks to the role that payment history plays in determining your credit score. You’ll benefit even if you don’t use the card.
Bear in mind, however, that the reverse is also true. If the primary cardholder is late on any of their credit card payments, your credit will also take a hit.
3. Consider getting a share-secured loan
A share-secured loan is a type of secured loan that can be a good option for building credit if you have some savings available to you.
Share-secured loans function in a similar way to credit-builder loans. With this type of loan, you borrow a set amount of money, and an equivalent amount of money in your savings account is frozen as collateral. You won’t be able to access these funds until the loan is paid off, and your lender will take the money from your account if you stop making payments.
Like other types of secured loans, share-secured loans involve less risk for the lender, making them easier to qualify for than unsecured loans. They do, however, involve some risk for you. Make sure that you always keep some money aside in case you’re faced with unexpected expenses.
4. Pay your bills on time
It might seem obvious, but this is the single best thing you can do to build and improve your credit if you already have open credit accounts. Your payment history is the key factor that determines whether you have good credit or bad credit.
Always budget carefully and avoid making late payments or doing anything else that could damage your credit. If you pay your bills on time, your credit is guaranteed to improve in the mid- to long-term.
