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Credit Builder Loans: A Complete Guide

Published August 20, 2021

8 minute read

Devon Taylor

By Devon Taylor

A credit-builder loan is exactly what it sounds like. It’s a type of loan that is designed to help increase you credit score. With a credit-builder loan, you actually pay the lender in equal monthly installments. The money is then deposited in a savings account for you. During the process, the lender reports the monthly payments to the major credit bureaus. That builds a history of positive payments on your credit history, allowing you access to more traditional loans in the future. Here’s everything you need to know about credit builder loans.

Forced Savings

A credit builder loan can also be thought of as a way of forced savings. You are essentially committing to a series of monthly payments, which will result in a lump sum being released to you at the end of the term. Those payments will improve your credit score with lenders and the credit bureaus. Unlike most types of loans, credit builder loans are generally only open to those with really bad credit — or no credit at all.

The good news is that credit builder loans are really easy to get, since there is minimal risk to the lender. After all, they aren’t really fronting you any money — they are just gathering your payments into a saving account for you and keeping the money safe.

How Credit-Builder Loans Work

Essentially, a credit builder loan works in the opposite way as a regular loan. The name is almost misleading, since you’re not actually being lent any more at all. You’re basically sending money to yourself in small increments, so that you have a larger sum at the end of the loan term. While you could easily save this money without using a credit builder loan, this financial product has one very specific advantage — the payments being reported to credit bureaus, which will improve your credit score.

When deciding on a potential lender for a credit builder loan, it’s important to look at the amounts offered and any interest or fees that may apply, either to the loan or to the savings account that will hold the money. You should also check if the saving account pays interest back to you on any balance it holds.

How To Open A Credit-Builder Loan

To open a credit builder loan, you’ll need to submit an application. The entire process is similar to applying for a normal personal loan or line of credit. The application typically requires information such as your address, income, employment status, and housing situation. Most applications also require proof of income and employment status.

Opening a credit builder loan account usually requires a small, one-time administration fee. Some lenders may also charge a fee for late payments. Once the application is approved, the lender will open a savings account for the person borrowing the money. The lender sets aside the amount of the loan in a savings account for you. However, you will not have access to the account until you pay off the loan amount in full, plus interest.

Woman with bad credit

Shutterstock

Making Payments

You then make payments in equal monthly installments. A typical credit builder loans lasts between six and 24 months, depending on how much you’re trying to save (or how many months of consistent payments you’re looking to add to your credit history). Most credit builder loans are for small amounts. They go as low as $300 and usually max out around $5,000.

The lender reports all your payments to the major credit bureaus. Beware, though, that they will also report any late or missed payments. So if you decide on a credit builder loan to increase your credit score, make sure you take it seriously. It could actually cause your score to drop if you start missing payments.

Remember that it’s best to only pay what the required amount every month. Even if you suddenly become flush with cash, the point of this loan is only to show that you can make consistent monthly payments over a long period of time. Paying it off early means fewer regular payments will show on your credit history, which won’t help your credit score as much. It could even cost you more money, as some credit builder loans charge early repayment fees.

Interest Charges And Fees

It’s also important to be aware that lenders still charge interest on credit-builder loans. Interest rates typically range between 6% and 16%, which is frankly not that attractive. However, the cost of this interest may be slightly reduced by interest gains you earn on the savings account (assuming that feature is offered to you). Ultimately, this is a short-term price you have to be willing to pay to boost your credit score with a credit builder loan.

As mentioned, there may also be some fees charged to process the loan application and open a savings account with the lender. These fees tend to be minimal, though. The funds in the savings account will be made available once you have finished making all of the payments. The lender will provide immediate access to the savings account or wire the money to an account of your choosing.

Managing A Credit-Builder Loan

Picking the right type of credit builder loan is critically important. You should only look for one with a payment you can afford. Stretching your budget further will only raise your risk of missing a payment and damaging your credit score. Most credit builder loans have terms that are less than 24 months (two years). Make sure you choose a loan that reports payments to all three major American credit bureaus.

Always make your payments on time. If you pay the loan as agreed, you build up good data on your credit reports. Remember that any payment more than 30 days will hurt your credit score. It might seem easy to neglect a payment. After all, you’re only paying yourself with your own money, just to get it all back in the end. So what’s the big deal if the amount is slightly lower, right? Well, your credit score will suffer if you miss payments. Since the whole point of this loan is to build your credit score up, don’t self-sabotage your efforts.

Where To Find A Credit-Builder Loan

Most credit builder loans can be found at credit unions or banks. Keep in mind that credit unions tend to have membership requirements, such as living in a particular county, working for particular companies, worshiping in a certain church, or making a small charitable donation. However, they may offer lower interest rates than traditional banks.

Another place that may offer credit builder loans is a Community Development Financial Institution (CDFI). These organizations exist to help lower-income communities. There are about 1,000 of them in the United States. An online search is usually sufficient to find lenders that offer credit builder loans. Not every lender is licensed in every state, though. It’s important to check that your lender is legitimate. In addition, payment amounts, terms, and interest rates can vary widely from place to place, or bank to bank.

A Word of Warning

If you’ve read this far, you might be thinking to yourself “what a minute, a credit builder loan isn’t really a loan at all!” Well, you’re absolutely right. If you need a loan to pay off an expected expense, a credit builder loan will not help you. This poorly named financial product can be very misleading, if you’re not careful. In fact, we previously wrote an article about someone who was duped into a “credit repair loan” (which is just the same thing, really) thinking he would receive the money up front, and then pay it back. That is, they are sometimes disguised as traditional loans to trick customers into agreeing.

These products are not really loans. They exist for one reason, and one reason only: to help improve your credit score. Make no mistake, though, you will absolutely pay for the service. If your credit score is suffering, a credit builder loan can help. However, there are a bunch of other ways to improve your score too, without agreeing to one of these forced saving programs.

Alternative Options

Credit builder loans are not the only to build credit or improve your credit score. Other options include getting secured credit cards, becoming an authorized user on someone else’s card, or taking out a traditional personal loan. Let’s look at a few of these alternative options.

Secured Credit Cards

Even those with bad credit (or no credit) can qualify for a secured credit card. You just have to put down the required security deposit — usually $200-to-$500. That deposit guarantees your payments in case you default. After 12 months, your deposit is returned to you and your secured credit card reverts to a regular credit card instead. If you don’t like the idea of a secured credit card, you might be able to qualify for a different kind of card. Just don’t expect the find one with great rewards or interest rates, since your credit score isn’t great.

Credit cards are one of the best ways to build your credit — as long as you use them responsibly. Credit card histories are always reported to the credit bureaus. So as long as you use them sparingly and always pay the balances off on time, regular credit card use can really boost your credit score over time.

Man with bad credit

Shutterstock

Authorized User

If you can’t get your own credit card (or don’t want one), you can try to become an “authorized user” on someone else’s account. If you have a family member or close friend you can ask, you can basically get a secondary credit card (with your name on it) attached their credit card account. As an authorized user, you can make purchases using the primary user’s credit line, the same as if the credit card was your own.

While an authorized user is able to make purchases on a credit card, they are not technically responsible for making payments on the card. That still falls on the primary cardholder, as does any interest accrued. That means that becoming an authorized user requires trust and communication. You don’t want to ruin a relationship over credit card misuse. However, if the primary credit card holder keeps the account in good standing, the credit score of the authorized user will increase as a result.

Personal Loans – Secured And Unsecured

Some lenders will offer regular personal loans to people with bad credit. However, they will likely charge high interest rates – as high as 35% or 40% in some cases. Federal credit unions cap the interest rates they charge at 18% and may accept applicants with bad credit. You might as well look into these, if you need a loan and/or are looking to improve your credit score.

Another alternative is a “secured personal loan.” This is where you must put up collateral to take out the loan (typically a vehicle, or other reasonably-valued asset). If you default on the loan, the lender can seize the collateral, sell it, and use the proceeds to clear the debt. Both secured and unsecured personal loans report payments monthly to the major credit bureaus.

The Bottom Line

Credit builder loans can be a good option for people who have bad credit or no credit history. For a few hundred dollars, you could use one to improve your credit score and your overall financial status. Just remember that you won’t actually get all your money back, as you’ll have to pay interest on the loan. For some people, though, the credit score improvement is worth the expense.

An improved credit score can help you get bigger loans (with better terms) in the future. The better your credit score, the easier other aspects of life may become, such as getting an apartment or even a job. Remember that there are alternatives to credit builder loans too, which may actually help you more while costing you less. Assess your financial situation and consider all options before deciding to proceed.

Devon Taylor

Managing Editor

Devon is an experienced writer and a father of three young children. He's simultaneously trying to build college funds and plan for an eventual retirement. He's been in online publishing since 2013 and has a degree from the University of Guelph. In his free time, he loves fanatically following the Blue Jays and Toronto FC, camping with his family, and playing video games.

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