Getting approved for a loan or mortgage can be difficult when you have no credit history or your credit score is on the low side. Lending often involves risk, and lenders are more willing to lend money—and draft better terms—to people who are in good standing with the credit bureaus. But, you can’t build good credit unless a lender gives you the chance to prove you’re worthy—so what next? This is where a credit builder loan comes in handy.
A credit builder loan doesn’t require good credit or a long credit history for approval—but you must have enough income to make payments. This loan is designed to help you build your credit as you make consistent payments toward your loan. Similar to other loans, a credit builder loan comes at a cost—you’ll pay some interest throughout the loan period.
Check out our guide to learn more about how a credit builder loan works, where to get it, the qualifying requirements, and your credit builder loan alternatives.
How Does a Credit Builder Loan Work?
Sometimes referred to as a “fresh start loan”, a credit builder loan is a small loan ranging between $500 and $5,000 whose sole purpose is to help you improve your credit score. It works the complete opposite of a traditional loan—a lender deposits the loan amount into a CD or savings account that you can’t access until you’ve repaid the total loan amount. But as with regular loans, you’ll pay an interest in the balance — anywhere from 6% to 22% depending on your lender.
In exchange for the payments you make, your lender reports this activity to the credit bureaus to help build your credit rating. Depending on your loan terms, you could make payments for a period of six to 24 months. Choosing a longer term will give you a more affordable monthly payment. Since the lender isn’t technically giving you money, a credit builder loan carries no risk for them. This makes this loan open and accessible to people who have no credit or have a poor credit standing.
The process of obtaining a credit builder loan is similar to how you’d go about obtaining a personal loan. You’ll need to start by comparing lenders, the loan amounts they offer, their APR range, and fees. After choosing a lender, you’ll need to submit your application — just as you’d do with a normal personal loan. Some lenders may require you to pay a one-time administrative fee to open a credit builder loan account.
Your credit builder loan starts functioning differently from a traditional loan after your application is approved.
- Your lender opens a savings account. Upon approval of your application, your lender sets aside the loan amount in your savings account. However, you won’t access this money until you repay the entire loan amount plus interest.
- Making payments. You’ll make equal monthly payments to your lender over a period of six to 24 months—depending on your loan amount and lender’s terms.
- Your lender reports the payments to credit bureaus. Every month, your lender will report your payment status to the credit bureaus—whether late or on-time. Your credit score should increase if you’re responsible and make timely payments.
- Your lender charges interest. The interest on your loan may range between 6% and 22%. However, you may pay a lower APR if your lender deposits the money in an interest-bearing account. Your lender may also reimburse some of the interest you pay when the loan period ends.
- Receive your funds. Upon completion of all payments on the loan, your lender will let you access the savings account or wire the money.
We recommend that you only pay what’s required of you by the lender each month. The whole point of a credit builder loan is to have your payments reported to the credit bureaus. Paying off your loan early will only translate into a shorter payment history.
Where to Get a Credit Builder Loan and What to Consider
You’ll probably not get a credit builder loan through a large financial institution—instead here are options to try:
Most of the large banks won’t provide credit builder loans—they’ll prefer that you go for a credit card instead. You may find credit builder loans available at regional or nearby community banks.
While most credit unions offer credit builder loans, you must be a member to apply. Most credit unions place your loan in a savings account that earns some interest. This may ultimately reduce the amount of interest you pay for servicing your loan. Credit unions also offer favorable loan terms.
Online lenders will help you build your credit without leaving the comfort of your home. Although you must pay a one-time registration fee ranging between $9 and $15, you can enjoy monthly payments as low as $25.
Remember, credit builder loans are not built the same — expect them to vary depending on the lender. Here’s what we recommend that you consider when looking for a credit builder loan:
- The Loan Size. Pay attention to the amount of money you can comfortably put into a CD or savings account—you won’t access it for 6 to 24 months. The larger the loan, the higher the monthly payments, so consider how much you can afford to pay every month.
- The APR. Annual percentage rate is the amount a lender charges to borrow the funds. Most credit builder loans have an APR of less than 10%—some may have higher rates. Look for the lowest rates
- Interest payments. Some lenders may keep all your interest or reimburse some money when you complete your loan repayment.
- Other fees. Some lenders may charge a one-time administrative fee for setting up your account while others will charge late fees for any late payments. You don’t want to incur too much of these additional fees.
- Minimum and maximum loan limits. You don’t want to borrow too little or too much. Ask your lender how much you’d need to take out for your specific needs.
- Terms and conditions. Be sure to review the terms and conditions before accepting a credit builder loan. Pay attention to aspects like grace period and prepayment penalties.
How a Credit Builder Loan Helps Your Credit Score
When you apply for a credit builder loan, your lender approves you for a certain amount—typically $500 to $5,000—and you make fixed payments on the loan for six to 24 months depending on the terms. The credit builder loan is just an installment loan (similar to an auto loan or mortgage) for which you’ll pay the principal and interest on the loan.
The monthly payments made to your credit builder loan are reported to credit bureaus, which will contribute to healthy credit scores. Accounting for 35% of your FICO score, payment history across your accounts is the main factor affecting your credit score— so it’s crucial that you maintain timely payments on your loan.
A credit builder loan lets you build credit if you don’t have any account, and can help restore your credit if you have some negative marks— such as missing payments—on your credit report. The loan will also help you nurture good financial behaviors that will prepare you for other financial products like credit cards.
While you’ll pay more interest if the loan term is longer, you may also enjoy more affordable monthly payments on a longer loan term. You’ll want to use a credit builder loan to build your credit history, so you won’t achieve that if you choose payments you can’t afford. After repaying the loan, your lender releases the money to your savings account for you to use as you please.
What Are the Requirements to Get a Credit Builder Loan?
Some requirements you must fulfill to get a credit builder loan include:
- You must be at least 18 years old
- Have a bank account and social security number
- Proof of income is particularly important when applying for a credit builder loan. Your lender wants to see that you earn enough money to be able to make the fixed monthly payments.
Be sure to shop around when looking for a loan since rates and terms will vary among lenders.
Credit-Builder Loan Alternatives
A credit builder loan isn’t the only way for you to improve your credit — there are a few other alternatives to give your credit profile a boost. Here are some alternative strategies you may use to build credit:
- A secured credit card. You can qualify for a secured credit card if you have bad credit or no credit at all as long as you can put down the minimum security deposit—usually $200 to $2,000. The deposit you pay becomes your credit limit, which the lender can take away if you can’t pay off the amount borrowed.
A credit card can help you build your credit profile since it reports to the credit bureaus every month—whether or not you make any purchases. You’ll quickly build your credit score if you make a small purchase and pay in full before the due date. Use your card responsibly and your bank may convert it to a regular unsecured credit card account. The trick is to always make on-time payments and ensure your card issuer reports the activity to the credit bureaus.
- Be an authorized user. As an authorized user on a credit account, you’re not responsible for making any payments but can still use the account. You can make purchases using the account while the primary card holder is responsible for making all payments. The payment history will appear on your credit report, so ensure the primary cardholder pays on time and that you both maintain a low credit utilization ratio. Just being associated with the cardholder’s great credit reputation helps yours as well.
- Secured personal loan. Some lenders will approve you for a secured personal loan—a loan backed by collateral—even if you have poor credit. While you can easily build credit with this type of loan, the prospect of losing your collateral upon default makes it a riskier option.
- Unsecured personal loan. You may also apply for an unsecured personal loan (one not backed by collateral) but you’re likely to pay a higher interest rate. The lender may assess your income and other financial obligations that determine your ability to repay the loan. Your lender may also ask you to place a security deposit.
A credit builder loan is an excellent tool to improve your credit profile, especially if you’re working from scratch or need to eliminate the negatives on your credit report. But, the inability to receive the loan money until you’ve paid it off can be a turn off for credit newbies. Be sure to assess alternative options like becoming an authorized user or opening a secured credit card to determine what best suits your needs.
Whatever method you choose, the rule of thumb is to make prompt payments each month. Late or missed payments will only hurt your credit scores. Carefully reviewing the loan terms and choosing the lowest cost option will help you get the most out of your credit builder loan. You don’t want to build credit at a huge cost.
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