Thanks to its low barrier of entry and relatively low cost, a credit-builder loan can be a terrific starting point on the path to good credit. Check with nonprofit lenders or your local bank or credit union to find the most favorable terms.
When you set out to build or rebuild your credit, you’ll no doubt face a dilemma: You need a positive credit history to prove that you’re a responsible borrower, but you can’t establish a positive credit history if no one will lend to you in the first place.
Credit builders often turn to secured credit cards or sign up as an authorized user on a family member’s card to get started, but you may have overlooked a unique lending tool that can help you tuck away money while boosting your score – credit-builder loans.
These small loans are designed to help consumers with bad credit or no credit history bolster their credit profile, and they can be a solid first step toward a financial milestone like applying for a credit card or taking out a mortgage.
Here we take a look at how credit-builder loans work, where to get one and how to tell if they’re the right credit-building tool for you.
What is a credit-builder loan?
A credit-builder loan is a small loan made by a credit union, bank, nonprofit or online lender that is designed to help consumers establish or improve their credit profile through positive payment history.
Like traditional personal loans, credit-builder loans carry fixed interest rates and repayment terms. But where personal loans offer money upfront in a lump sum that you must pay back over time, credit-builder loan lenders typically freeze your funds in an account while you make payments. Only after you’ve paid off the loan balance do you get access to the money.
See related: Personal loan vs. credit card
How does a credit-builder loan work?
Credit-builder loans are usually offered in modest amounts ranging from under $500 to around $1,500 and are geared toward consumers who need help building or rebuilding credit, but who otherwise have stable finances.
Because loan funds are held in an account until you finish paying, credit-builder loans are less risky for lenders than traditional unsecured credit cards or personal loans. This makes approval easier and gives borrowers with a damaged or thin credit file a chance to demonstrate their creditworthiness by paying on time and in full.
Lenders structure the loans in different ways, but credit-builder loans usually follow a similar pattern. Here’s a step-by-step breakdown of different types of credit-builder loans, how they work and how they can help you build credit.
1. The lender opens a savings account
With a “pure” credit-builder loan, the lender deposits the loan amount into a locked savings account or certificate of deposit (CD) and gives it to the borrower only after receiving the final payment. In this scenario, the loan essentially secures itself, so the lender assumes minimal risk.
“It’s very safe for the customer and very safe for the issuer,” says Sarah Chenven, chief operating and strategy officer at Credit Builders Alliance, a nonprofit organization that aims to improve consumer access to credit. “You’re basically prepaying the loan.”
There are two upsides to this type of loan: You don’t have to come up with cash upfront to secure the loan and you end up with a nest egg.
Other credit-builder loans, called secured credit-builder loans, use the money you already have in a savings account or CD to secure your loan funds. In this case, the funds are either locked until you finish paying off the loan plus interest or released incrementally as your loan balance decreases.
“The challenge is, do you have the money to put down?” says Chenven.
2. You make payments and the lender reports to credit bureaus
Next, you make equal monthly payments, usually over the course of six to 24 months, and your lender reports your payment activity to the national credit bureaus. Payment history is the most impactful of the five credit score factors, accounting for 35% of your score, so regular, on-time payments can go a long way toward building your credit.
“The most important thing is that you do not miss payments,” says Beverly Harzog, credit card expert and consumer finance analyst for U.S. News & World Report. “You have to pay on time by the due date – that’s the only way a credit-builder loan is going to help you build credit and increase your credit score.”
While you may get impatient and want to pay off your loan early, the whole purpose is to build credit, and credit takes time. Just continue to make your regular payments and you should see incremental progress.
See related: How long does it take to rebuild credit?
3. The lender charges interest
The lender will also charge interest on your loan, ranging from around 6% to close to 20%, depending on the terms of your loan. The low end of this spectrum is extremely low compared to typical credit card interest rates, and even the high end is lower than you’ll find on most credit cards designed for someone with bad credit.
Keep in mind, too, that this rate may be offset if your loan funds are put in an interest-bearing account. Some lenders may even give you back a portion of your interest if you pay on time. For example, 1st Financial Credit Union offers credit-builder loans ranging from $300 to $1,000 over 12 months and will refund half of your interest back to you if you make your loan payments on time.
4. The lender releases the funds
Once you’ve paid off your loan, the lender will unfreeze the account and give you access to the funds or send the money to an account of your choosing.
If you’ve been diligent about paying on time and in full – and assuming you haven’t run into any other credit trouble in the meantime – you should end up with an improved credit score and a decent chunk of savings.
Consumers may go from no FICO score to the mid-to-upper 600s, or in some cases up to 700, during the loan period, Chenven says. Generally, though, a score might go up about 20 to 25 points over the life of the loan.
Pros of credit-builder loans
Credit-builder loans offer a few key advantages over other credit-building options like credit cards and traditional personal loans. Here are a few of the main reasons to consider a credit-builder loan:
- Potentially lower upfront cost – Credit-builder loans that are secured by the loan funds themselves are ideal if you’d rather not tie up a large chunk of money as a deposit. With secured credit-builder loans and secured credit cards, you usually need to come up with $200 or more just to get started.
- You’re saving at the same time – If you struggle with overspending or haven’t started an emergency fund, a credit-builder loan could be a great way to gradually save money and keep it locked in an account where you won’t be able to touch it. “A credit-builder loan is good for consumers that struggle with controlling their financial spending habits,” says Jared Weitz, CEO and founder of United Capital Source Inc. “Instead of growing credit by taking out a traditional loan or new credit card, you learn how to practice saving as a part of your financial strategy and build your credit score simultaneously.”
- You can increase your credit mix – If you combine a credit-builder loan with other credit-building tools like rent reporting or secured credit cards, you can demonstrate your creditworthiness with multiple credit types and increase your credit mix. Though credit mix only makes up about 10% of your FICO credit score, every bit of positive data helps, especially if you’re starting with a thin file or no credit score.
Cons of credit-builder loans
While credit-builder loans are generally a solid starting point for anyone who wants to build or rebuild credit, there are a few downsides to consider.
- Secured credit-builder loans require money upfront – Like secured credit cards, secured credit-builder loans require you to tie up a chunk of money to start, often for a year or more. If you’re short on funds or facing immediate financial challenges, that could be a deal-breaker.
- Revolving credit has a bigger impact on your score and gives you buying power – “A secured credit card can be an even more powerful credit-building tool because it’s a revolving trade line,” says Chenven. “If you’re successful with it, you’re going to benefit even more from a score perspective. It also gives you a certain level of flexibility because you then have immediate access to the capital.” If you’re willing to put down a deposit, you can even find high limit credit cards designed for building credit.
- You can’t avoid interest – Since the purpose of a credit-builder loan is to build credit incrementally, there’s not much point in paying off the loan early. As a result, you’ll be stuck paying interest on the loan for a year or more, without actually getting access to your funds. If you opted for a secured card instead, you could both build credit and avoid interest by paying off your card balance in full each month.
- It won’t help much if your score is already in decent shape – Credit-builder loans are ideal for those with a thin credit file or a severely damaged score. If your score falls somewhere in the middle of the spectrum or if you’re already in a good position, a credit-builder loan may not make much of an impact.
See related: Credit builder card reviews
How to get a credit-builder loan
“Credit-builder loans come in many shapes and sizes,” Chenven says, noting that some of the organizations that are members of the Credit Builders Alliance offer the loans only to “target markets,” such as domestic violence survivors, people with disabilities, refugees or youths.
You can start by asking your own bank if it offers a credit-building loan, then check local credit unions. “They know you, and they’ll be more likely to approve you,” says Harzog.
Here are a few places where you may find credit-builder loans available:
- Community banks and credit unions – These institutions tend to have a closer relationship with their customers and can offer credit-builder loans at low cost. “Because of their community focus, credit unions typically have better rates and terms and are more willing to work with you,” says Brad Sturgis, founder of FinancialSailor.com. “The only catch is that you have to live, work or be going to school in a particular area to become a member.”
- Nonprofits – “Nonprofits provide the lowest cost for credit-building loans, and you can sometimes even make money through a match,” says Jeff Zhou, founder of the online lender Fig. “The Local Initiatives Support Corporation is an example that has a great program for credit building. The trade-off is that it often has to be done in person and can be harder to use regarding making and scheduling payments.”
- Online lenders – “We’re seeing more and more online lenders that are for-profit but very mission-driven and have access to capital in a way that makes them able to more efficiently offer credit-builder loans and achieve a scale that nonprofit nondepository institutions cannot achieve,” says Chenven. Just be sure to do your homework on an online lender’s reputation and read your loan terms carefully before you commit. “Any of the options can be good, as long as – definitely on the online side – you’re doing an extra layer of due diligence,” says Chenven.
Whether you’re brand-new to credit or carrying a damaged score due to job loss, medical illness or a phase of reckless spending that’s now behind you, a credit-builder loan can be a great starting point on the road to better credit, says Harzog. “It gives you a chance to clean up the past and move forward.”