What is a Credit Builder Loan?

Are you looking to start building credit or improve your credit score? Are you hoping to finance a car, rent an apartment or get a new credit card some day? Whether you’re starting from scratch or want to strengthen your credit profile, a credit builder loan could be the stepping stone you need to achieve your financial goals.

Credit builder loans are designed to help people without a strong credit history build a track record of making loan payments that can help them qualify for more credit in the future. With a credit builder loan, you don’t get access to the funds until you’ve paid it off — they’re not intended for people who have an immediate need.

Credit builder loans may be especially helpful for people who aren’t carrying any other debt. According to a 2020 study by the Consumer Financial Protection Bureau, borrowers with no other debt saw their credit scores rise an average of 60 points after paying off a credit builder loan. And borrowers who didn’t have a credit score before were 24% more likely to have one after paying off their loan.¹

But no loan can guarantee better credit, so it’s best to know the facts before applying. Let’s dive deeper into what a credit builder loan is and how it works, so you can decide whether it’s a good fit for your financial goals.

How does a credit builder loan work?

With a traditional loan, you receive a lump sum of money upfront and repay it through fixed monthly payments plus interest (the cost of borrowing). A credit builder loan, however, works in the opposite way. If you’re approved, the lender will hold the total amount you borrowed in a savings account or a certificate of deposit (CD) while you make monthly payments to repay the loan.² The funds will stay in these accounts until you’ve repaid your loan.

After you pay off the loan at the end of the term, you’ll have access to the money that was stored in the savings account.³ If your lender puts your loan in an interest-bearing account, you may also earn interest that can offset part of the interest and fees you pay on the loan.⁴

While credit builder loans vary by lender, they’re usually available in borrowing amounts of $300 to $1,000, with terms ranging from six to 24 months.⁵

Credit builder loans may be easier to qualify for than other loans, because they’re less risky to the lender. And your credit score may increase over time if you make consistent, on-time payments, as long as your lender reports your activity to the three major credit bureaus (Experian, TransUnion and Equifax). However, if you don’t make your payments on time, you could hurt your credit score. Also, it’s important to remember that you won’t get your funds until after you’ve made all your payments, so a credit builder loan may not be a good idea if you need cash fast.⁶

Pros and cons of credit builder loans

Credit builder loans can be a good choice for specific needs, but it’s important to understand their limitations as well.

Pros

• Relatively easy to qualify for: Credit builder loans are designed for people with little to no credit, so your credit score may be less of a barrier.
• May help build credit: If you make your payments on time, every time, you may see your credit score improve.
• Can help you save: Once your loan is paid off, you’ll have access to your loan funds, which you can use to build your savings.

Cons

• Delayed access to funds: With credit builder loans, you won’t get access to the loan funds until you’ve paid it off. It’s not a good choice if you need funds fast.
• Less likely to help those with existing debt: If you already have debt, a credit builder loan may not help your credit score much.
• Fees and interest may reduce loan amount: Credit builder loans aren’t free. The fees and interest that you pay may eat into your final payout. If you’re primarily using a credit builder loan as a way to save, there may be less expensive options.

Where to find a credit builder loan

Credit builder loans may be hard to find at major banks.⁷ But you may still find credit builder loans with the following lenders:

• Community banks and credit unions: Some locally owned banks and credit unions may offer credit builder loans. Depending on their policies, you may need to be a member or have an account with them already.
• Community Development Financial Institutions (CDFIs): CDFIs are financial institutions that support low-income or disadvantaged members of the community.⁸ You might be able to secure a credit builder loan from a CDFI if you meet the requirements.
• Online lenders: Some online lenders offer credit builder loans to those who want to build their credit score, but they may not offer these loans in every state.⁹ It’s important to research lenders to determine what they offer in your area.

How to apply for and manage a credit builder loan

Below are some helpful tips to get started if you’re interested in a credit builder loan:

• Check your credit: Start by finding out where your credit stands so you can get an idea of how to improve it. You can check your credit for free using a credit monitoring tool, or you can get a free credit report from AnnualCreditReport.com once per week.¹⁰
• Review your budget: Review your income and monthly expenses to figure out if you can comfortably afford to repay a credit builder loan each month along with your other expenses.
• Shop around: Do your research to find a few credit builder loan lenders. Some lenders will allow you to prequalify online so you can get an idea of the loan amount and interest rate you might qualify for before you fully commit to submitting an application. During prequalification, the lender will often perform a soft credit pull, which lets them look at your credit history without affecting your credit score.¹¹
• Apply: Now, it’s time to fill out an application. You can apply online or in person at a local branch, depending on the lender you decide to move forward with. Be prepared to provide personal and financial information like your address, proof of income and banking info. Applying for a loan will trigger a hard credit pull with the major credit bureaus that could temporarily lower your credit score by a few points, so make sure you know which type of loan you want and are likely to qualify for before applying.¹²
• Make payments on time: If you’re approved for a credit builder loan and accept the loan offer, you should have a solid plan for how you’ll repay the loan on time each month. Late or missed payments can make the journey to an improved credit score more challenging.

Alternatives to credit builder loans

If you decide not to get a credit builder loan, there are other options for people without a strong credit history. You could apply for a secured credit card or secured personal loan to help you build credit. Some less traditional options, like lending circles, may also let you borrow money and build credit at the same time.

Personal loan

A personal loan can help you build credit with on-time payments.¹³ A personal loan is a lump sum of money that you borrow for a wide range of purposes, such as medical bills, car repairs and more. Personal loans may be unsecured or secured.

A secured personal loan is backed with something valuable called collateral, like a car. Secured loans may offer higher borrowing amounts and lower interest rates than unsecured loans, and they may be easier to qualify for if you don’t have a strong credit history.

There are eligibility requirements for the collateral you offer the lender, like the condition and age of your vehicle and proof of insurance. If you don’t make your monthly payments, the lender has the right to take possession of your collateral to recover the amount you owe.

An unsecured loan doesn’t require collateral — instead, the lender typically considers your income and credit history. OneMain, works with a wide range of customer credit scores and take your whole financial picture into account to help you find a loan that’s right for you.

Secured credit card

With a secured credit card, you pay a cash deposit, which is usually equal to your credit limit.¹⁴ For example, you can pay a $500 deposit to open your account, and the credit limit will be the same amount. The funds act as collateral to reduce the lender’s risk in case you don’t repay the card balance.¹⁵ You can use a secured card just like an unsecured credit card, but it’s important to use your credit card responsibly and keep your balance low.

If you pay your balance in full on time each month, the credit card issuer will report your positive payment history to the credit bureaus, and you may see your credit score increase. ¹⁶ The issuer may also upgrade your secured card to an unsecured credit card, increase your credit limit and return your deposit.¹⁷

Remember that applying for a new personal loan or credit card could trigger a hard credit inquiry, which could cause your credit score to take a slight dip. Hard inquiries usually stay on your credit for up to two years.¹⁸

Lending circles

A lending circle is a group of people who lend and borrow money from each other.¹⁹ Each member contributes a set amount of money into a pool on a regular basis. Each person then takes turns borrowing the entire pool for their own use, and the process continues until everyone has had a chance to borrow. While informal lending arrangements typically don’t affect your credit, some nonprofit companies, like the Mission Asset Fund, help people form lending circles that do report payments to the three credit bureaus.²⁰

Build your credit with confidence

Along with building healthy financial habits, a credit builder loan could be a good way to help boost your credit score and overall finances. Be sure to consider other options like a personal loan or secured credit card before you apply — they might offer better terms for your budget.

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1.https://files.consumerfinance.gov/f/documents/cfpb_targeting-credit-builder-loans_report_2020-07.pdf
2,4,6. https://www.bankrate.com/loans/personal-loans/pros-and-cons-of-credit-builder-loans/
3. https://www.experian.com/blogs/ask-experian/what-is-a-credit-builder-loan/
5,8. https://www.nerdwallet.com/article/loans/personal-loans/what-is-credit-builder-loan
7. https://www.experian.com/blogs/ask-experian/should-i-get-a-credit-builder-loan-or-a-secured-credit-card/
8. https://www.cdfifund.gov/about
10. https://www.annualcreditreport.com/gettingReports.action
11,12. https://www.myfico.com/credit-education/credit-reports/credit-checks-and-inquiries
13. https://www.nerdwallet.com/article/loans/personal-loans/personal-loan-affect-credit-score
14,15,16,17. https://www.investopedia.com/terms/s/securedcard.asp
18. https://www.experian.com/blogs/ask-experian/what-is-a-hard-inquiry/
19. https://www.nerdwallet.com/article/loans/personal-loans/lending-circles-help-borrowers-build-credit
20. https://www.missionassetfund.org/