Highlights
- Credit-builder loans help those with little to no credit build credit quickly and easily.
- The lender deposits your payments into a CD or savings account until you’ve made all your monthly payments. Then, you gain access to the funds.
- There are some fees associated with credit-builder loans, although they’re often low.
Realizing you have a low credit score — or no score at all — can be alarming, especially if you learn this information via a denied loan application. But if you’re a borrower with a less-than-stellar score, there are ways to get yourself where you need to be.
One of those ways is a credit-builder loan. But credit-builder loans don’t work like traditional loans, and they aren’t right for everyone. Before you sign on the dotted line, learn what a credit-builder loan is, how it works, and who it’s right for.
What Is a Credit-Builder Loan?
Credit-builder loans are small (fake) loans with low fees that help bad-credit or no-credit borrowers build or rebuild credit. Credit-builder lenders report your monthly payments to the credit bureaus, increasing your credit score if you regularly pay in full and on time.
At the end of the loan, you get the principal (amount borrowed) back, and they keep the interest you paid and a small administrative fee as payment. Some lenders may let you keep at least a portion of any interest your money earned while in savings.
How a Credit-Builder Loan Works
When you apply for most loans, you’re probably looking to have the cash sent to you ASAP. With credit-builder loans, you don’t receive the borrowed amount upfront. Instead, the lender holds it in a secure account, such as a certificate of deposit (CD) or savings account, for the duration of the loan.
You then make regular monthly payments, including interest, toward the loan, which the lender reports to at least one credit bureau, often all three.
As you continuously make on-time payments, you establish a positive payment history, which helps your credit score tick up. Once you’ve made all the payments you agreed to, the lender releases the funds back to you minus the interest you paid, which they keep as part of their payment for services rendered. Some lenders may also let you keep any interest the principle earned while in savings, but that’s likely to be a small amount.
Features of a Credit-Builder Loan
Credit-builder loans are a financial stepping stone designed to help those with low or nonexistent credit scores. As such, they have several features that distinguish them from traditional loans.
Building or Rebuilding Credit
First and foremost, a credit-builder loan is entirely designed with one purpose in mind: to help borrowers build or rebuild their credit scores. The way the loan works helps you avoid getting into debt by taking on more than you can realistically pay back.
Credit-builder loans are typically smaller loans, and you can’t just take the money and run. Instead, you make the payments first and get most of the money back at the end of the loan, minus the interest fee for their services.
Meanwhile, the lender reports your timely payments to credit bureaus like Experian, Equifax, and TransUnion, helping you establish a strong credit score.
Most lenders report to all three bureaus, but a few just report to one or two, so double-check. Traditional lenders may only check one bureau, and it would be unfortunate to miss a borrowing opportunity because your credit-builder loan didn’t end up on all your reports.
Also note that some lenders report missed payments in addition to on-time payments, which has the potential to negatively affect your score. Fortunately, most lenders only report the good stuff.
Savings Component
One unique aspect of a credit-builder loan is that it’s actually a type of forced savings, which gets you into the habit of saving at least a small amount each month. The lender only keeps the interest you pay (plus the upfront fee you paid). It puts the principle into a savings account or CD and saves it for you.
You get that part back at the conclusion of the loan. They may also give you some or all the money it earned in interest, though that’s likely to be a lot less than you paid.
Don’t blow it all in one place. No, really. It’s best to put it into a high-yield savings account to continue earning interest.
Accessible to Individuals With Limited Credit History
Most lenders accept good- or excellent-credit borrowers. If you make enough money, a fair credit score can get you in the door. But it’s difficult to get a loan if you don’t have fair or better credit. And it’s difficult to build better credit if you can’t take out a loan. That’s where credit-builder loans come in.
They allow individuals with limited or even damaged credit history the opportunity to get all-important installment credit payments on their credit reports.
Loan Amounts & Repayment Terms
The loan amounts offered by credit-builder loan programs can vary, but you’re not going to find million-dollar options. You can typically get a credit-builder loan for between $200 to $5,000, with other lenders going higher for certain borrowers.
Credit-builder lenders structure their terms (loan lengths) to be manageable, usually ranging from six months to two years, allowing borrowers to make consistent payments with very small monthly installments.
Fees & Interest Rates
Credit-builder lenders are in the business of making money like every other loan provider. So they charge fees and interest.
But rates are generally reasonable compared to other types of loans, at least for the credit score ranges their clients usually have. Rates often start around 8% and range up to 20%. Other companies charge flat monthly rates for their credit-building products. Expect to pay a few dollars to $20 or more.
Lenders understand the purpose of these loans and aim to provide an affordable option for borrowers. Still, review and compare fees and interest rates from different lenders so you know you’re getting the best possible terms.
Cancellations
Since credit-builder loans are essentially fake loans, you can typically cancel them at any time. In some instances, if you owe more in fees than is currently in your savings account or CD, you have to pay the difference to fully close the account.
But not all lenders charge cancellation fees. It’s always a good idea to connect with a representative if you’re unsure of any potential fees or issues closing your account.
When you close a credit-builder account, know that you won’t see the positive impacts of a loan brought to full term. You’re missing out on the reported monthly payments, so your credit history won’t look as long for this line on your credit report.
Pros & Cons of Credit-Builder Loans
Credit-builder loans are straightforward loans meant to help anyone with bad credit, and they come with many perks. But there’s no denying these loans aren’t for everyone.
Pros
- Easily establish credit
- Develop financial discipline
- Cancel whenever you need to
Cons
- Tie up your cash
- Pay fees and interest
- Could damage your credit score
Pros
When used correctly, there’s a lot of good a credit-builder loan can do, especially for those who haven’t been able to build credit in other ways.
- Easily establish credit. When you make on-time payments, credit-builder loans help you build credit in potentially just a few months. You’re also taking on a new type of loan, which can diversify your credit mix, potentially helping your score.
- Develop positive financial habits. Since there’s a big incentive (a big chunk of cash) for you to continuously make payments on time, credit-builder loans help you develop beneficial money habits. That can help later when you apply for traditional loans.
- Cancel whenever you need to. Unlike traditional loans, you can cancel your credit-builder loan if you can’t fit the monthly payments into your budget.
Cons
All loans come with a few catches you need to be aware of. Credit-builder loans are no different, and there are downsides you should consider.
- Tie up your cash. Unlike traditional loans, credit-builder loans keep the money in an account for you until you’ve made your final payment. So you can’t use the funds for months or even years.
- Pay fees and interest. Credit-builder loans generally have reasonable fees and interest rates, but these are still costs you need to think about. Is it worth it for you to pay these fees to build credit quickly? Or can you do it on your own and avoid these fees?
- Potential damage to your credit score. Just like any other loan, missed or late payments on a credit-builder loan can negatively impact your credit history and score.
Will a Credit-Builder Loan Work for You?
Unlike many loans, credit-builder loans have a very specific purpose, meaning they’re intended for a certain type of person. You can expect a credit-builder loan to work for you if you meet all of the following criteria:
- You have bad credit or want to improve already-great credit. A credit-builder loan provides an opportunity to rebuild and repair your credit by establishing a positive payment history. Credit card borrowers with excellent credit can also use them to diversify their credit mix. They probably won’t help anyone in between much.
- You can make payments every month. Even though a credit-builder loan isn’t a loan in the same sense as other loans, you still need to have a reliable income that can help you make the monthly payments you agreed to.
- You don’t need the money right away. If you need emergency funding, a credit-builder loan won’t work for you since it ties up your money until you’ve fully paid the loan back. But there are personal loan options for those with bad credit.
- You’re comfortable paying fees. While these loans can help you build credit quickly, if you don’t want to pay any fees on your credit-building journey, you may have to look elsewhere.
Applying for & Managing Credit-Builder Loans
If you’ve decided a credit-builder loan sounds worthwhile, you need to understand how the application process works, as well as how to manage the loan over its entire term. Luckily, the whole process is simple.
Finding a Credit-Builder Loan
Many banks, credit unions, and online lenders provide credit-builder loans, but each does so on different terms. Look through as many lenders as you can, and compare:
- Fees
- Loan amounts offered
- Terms offered
- Early repayment options
- Which credit bureaus the company reports to
A quick internet search using the term “best credit-builder loans” can help you find dozens of lists with credit-builder loan options.
Application Process & Approval
The application process for credit-builder loans typically involves filling out an application form and submitting any additional paperwork the lender requires, such as:
- Proof of identity
- Proof of income
- Social Security number
- Consent to run a credit check
Eligibility criteria vary among lenders, but credit-builder loans are generally accessible to most borrowers who have an income, including those with limited or no credit history.
Responsible Loan Management
Once you get a credit-builder loan, you must properly manage the payments throughout the entirety of the loan. If you can’t, that could hurt your credit score.
To ensure successful loan repayment:
- Prioritize making timely payments.
- Avoid late or missed payments.
- Don’t borrow more than you can repay.
- Create a budget that includes your monthly payments.
- Contact your lender if you ever need to adjust or miss your payment.
Credit-Builder Loan FAQs
Credit-builder loans offer a unique approach to building or improving credit, and understanding their nuances is crucial to making informed decisions.
How Much Can You Get for a Credit-Builder Loan?
Credit-builder loans come in smaller loan amounts compared to traditional loans. These amounts can range from just a few hundred dollars to a couple thousand, although some lenders may offer higher loan limits.
Can I Pay Off a Credit-Builder Loan Early?
Your lender determines whether you can pay off your credit-builder loan early. Most lenders allow it, but some charge a penalty for doing so, while others don’t. Before paying off your loan early, review the loan agreement or contact the lender to ask about their policies.
But also think of the potential impact on your credit-building goals. Early repayment can feel good and help you close the loan sooner, but it also results in a shorter credit history, potentially impacting your credit score.
How Much Does a Credit-Builder Loan Help Your Credit?
If you have no credit score, don’t expect it to jump up to excellent just because you got a credit-builder loan. To earn an excellent credit score, you must maintain a healthy mix of credit and make payments on time for years.
Still, credit-builder loans can help get you started. A 2020 Consumer Financial Protection Bureau study found that those without existing debt saw an increase of 60 points, while those with some existing debt saw a 24-point increase.
How Fast Does a Credit-Builder Loan Raise Your Score?
While you’re paying the loan, you’ll likely see your score increase by a few points here and there as the lender reports your on-time payments. You’ll see the full benefit of your credit-builder loan once you’ve reached the end of the repayment period.
Final Word
Credit-builder loans have a simple purpose: to help you build credit. For those who have struggled to build credit on their own, that may be an ideal solution. Credit-builder loans are often small but mighty, with each payment you make reported to the credit bureaus so you can start building or rebuilding your credit.
But credit-builder loans aren’t the ideal solution for every low-credit individual. Other credit-building options may be more suitable.
For example, secured credit cards often come with no annual fees — just an initial (refundable) deposit that creates your credit line. Or you can opt for a student credit card if you’re a college student looking to build credit for the first time.
No matter the option you choose, consistently making all your bill payments on time, only applying for credit when you need it, and diversifying your credit products over time also contribute to growing your credit score.
