Credit Builder Loan: How It Helps Your Score
8 MIN READ
Published October 10, 2023 | Updated November 09, 2023
If you have no credit history or if you have poor credit scores, a credit-builder loan can help. When you apply for the loan, the lender will agree to lend you money, which will deposited into a locked credit-builder account. You’ll then start making loan payments, and once the loan is fully paid off, you’ll get access to the funds. The lender will report the payments you make to the three credit bureaus, which will boost your credit.
What Is a Credit-Builder Loan?
Credit-builder loans are small loans for those with no credit history. These loans are specifically designed to help you if you are trying to build or improve your credit profile. The lender will deposit a small loan amount into a locked savings account for a predetermined amount of time. You’ll make monthly payments, and once you’ve repaid the loan in full, you’ll get access to the loan proceeds.
For lenders, these loans are less risky because the loan funds are not distributed until you’ve repaid the loan. Timely payments can help you build a positive credit history. Lenders typically offer loans from $300 to $1,000, and repayment terms can range from 6-24 months.
How Credit-Builder Loans Work
Community banks and credit unions usually offer credit-builder loans. With conventional loans, you’ll get the money from the lender first and then pay it back over time. When you apply for a credit-builder loan, the lender will hold back the loan amount while you make the payments. You’ll receive the loan funds once you’ve made all the payments.
The payments you make are reported to the credit bureaus. Your credit score is calculated based on the information in your credit report. If you make timely payments, you’ll establish a positive payment history, which can help your VantageScore and FICO score.
Pros and Cons of Credit-Builder Loans
Credit-builder loans offer a range of benefits if you’re trying to establish a strong credit history. But it’s also important to be aware of some of the drawbacks so you can avoid any potential pitfalls. Here are some pros and cons to consider:
- Credit-builder loans are easier to qualify for when compared to prequalifying for a personal loan.
- If you make loan payments on time, you’ll be able to improve your score and build a good credit history.
- Once you pay off the loan, you may be able to see a 60-point increase in your credit score if you have no other debt.
- With a good credit score, it’ll be easier for you to qualify for credit cards and loans at a lower interest rate.
- You’ll only be able to receive the loan amount at the end of the loan term.
- Other than the interest rates, there may be other costs and fees involved, which can increase the total loan cost.
- If you miss payments or pay late, it can impact your credit score negatively.
“Credit Builder loans are a great way to help a consumer with bad credit to start building good credit again,” shared Teresa Dodson, debt expert and founder of Greenbacks Consulting. “Typically, these loans are $1,000 or lower, so this makes repayment realistic and affordable, and you can start seeing results quickly,” Dodson adds.
The 3 Types of Credit-Builder Loans
There are several different types of loans and financial products that can help you build credit. Below are three options to consider.
1. Secured Loans
If you are unable to qualify for a traditional loan, one option is to apply for a secured loan. If you have a valuable asset, such as a vehicle or property, you may be able to get a loan against it. For a lender, there is less risk involved since they can use the collateral to recoup the losses in case you default. As you continue to make timely payments on the loan, your credit scores will improve. Another option is to get a secured credit card, or to become an authorized user on someone else’s credit card.
2. Unsecured Loans
Unsecured credit-builder loans do not require any collateral. Many credit unions offer borrowers an unsecured loan or a credit card with a low credit limit, even when they have a poor credit score, as long as they have a bank account in good standing. If you use your credit wisely and pay the installments on time, your credit score will go up, and you may be able to qualify for traditional loans in the future.
3. Personal Loans
Some lenders offer personal loans for bad credit or with no credit. This can be a good way to build your credit if you manage to pay back the loan on time. In most cases, these installment loans carry a high-interest rate, so it’s important to ensure you’ll be able to afford the monthly payments and limit the amount you borrow.
How To Pick a Credit-Builder Loan
Credit-builder loans can be an effective way to start building your credit history. But with so many options available, it’s important to compare your options and choose a loan product that fits your individual needs.
Considerations When Choosing a Credit-Builder Loan
Here are a few important considerations to keep in mind before you apply for a credit-builder loan:
Find lenders that offer credit-builder loans. Not all banks and lenders offer these loans. Start by getting in touch with your local credit union to see if they offer such products. You may also be able to find online lenders that offer this option.
Determine how much loan amount you want to apply for, based on how much monthly payment you can afford.
Terms vary by lender, so it’s important to shop around and compare your options. Compare interest rates and any fees that the lender may charge to calculate the total loan cost.
Ensure the lender reports to all three reporting agencies- TransUnion, Experian, and Equifax.
Comparing Credit-Builder Loans
Not all credit-builder loans are the same, and it’s important to compare your options to ensure you’re getting the best possible terms. Terms vary by lender, but generally the interest rate ranges from 6% to 16%. Lenders may also charge late payment fees, administrative fees, and other fees, so it’s important to check the lender’s policy before you sign the loan agreement. If the lender has a prequalification process, it’s best to prequalify so you can get a clear idea of the interest rate you qualify for. Compare at least three lenders before you select one that offers the lowest possible annual percentage rate (APR), which is an important factor in determining the best credit-builder loan.
Impact of Credit-Builder Loans on Credit Scores
While credit-builder loans are typically offered to buyers with no credit history or low credit scores, it’s important to understand how these loans can impact your credit. Moreover, it’s also important to remember that these loans can also have a negative impact on your credit score if you’re not careful.
Positive Impact of Credit-Builder Loans
Lenders use your credit score to determine your ability to repay your debts. Those with low or no credit scores are risky borrowers. When you borrow a credit-builder loan, lenders will report your repayment activity to all three major credit bureaus- TransUnion, Experian, and Equifax.
Your payment history is the most important component of your credit score. When you make regular payments on your loan, it demonstrates your ability to repay and helps you build a foundation of a good credit history.
Negative Impact of Credit-Builder Loans
While a credit-builder loan can help you build your credit, it’s also important to remember that missing even a single payment can have a negative impact on it. Late payments can appear on your credit report once you’re 30 days due and they can stay there for seven years. So it’s important to avoid this pitfall and ensure that you do not miss a single payment if you’re hoping to improve your credit score.
The Bottom Line on Credit-Builder Loans
Whether you’re someone young who is just starting your financial journey, someone who hasn’t used credit in years, or someone with a poor credit history, you may be able to get approved for a credit-builder loan. But if you existing debt, it’s important to keep up with those payments while you pay back the credit-builder loan. It’s also important to ensure you only borrow as much as you can afford to pay back.