Credit-Builder Loans: What To Know Before You Borrow

Getting a credit-builder loan is similar to getting any other type of loan. You must show that you earn enough income to make the payments, verify your bank account and address and provide a government-issued ID. Unlike a regular loan, however, you don’t get any funds in your pocket until you’ve made all the agreed-upon payments.

A credit-builder loan can be a great tool to improve your credit score after a rough financial patch or start to build a score if you don’t have one. You can choose the loan amount and length of the repayment term, and lenders report your monthly payments to the credit bureaus — just like with a traditional loan. If it’s the right choice for your finances, you can follow a few simple steps to take one out.

What is a credit-builder loan?

A credit-builder loan is a special type of financing designed to give individuals with no credit history or a poor credit score a chance to prove their creditworthiness. Unlike a traditional loan, where you receive funds upfront and repay the money over time, a credit-builder loan works in reverse: You make scheduled payments and receive the balance at the end of the repayment term. The lender holds the total loan amount in a secured account until the loan is paid off.

Every payment you make on a credit-builder loan is reported to credit agencies, and over time, the payments can help boost a bad score or build a credit history if you don’t have a score. Once you’ve made all the payments, you’ve built a satisfactory history with the lender and can access the full amount you borrowed.

Why should you consider a credit-builder loan?

Once you have a credit score and positive payment history, you can apply for other credit products to help you along your financial journey, such as credit cards, personal loans or a mortgage.

But a credit score is important for more than just financing purchases — you may be required to have a good credit score to land an apartment, get a good insurance rate and, in some cases, open a utility account.

Where to find a credit-builder loan

You can get a credit-builder loan from several places, including:

• Credit unions: Credit unions often offer lower rates than some larger banks since they are member-owned, not-for-profit institutions. You must become a credit union member before borrowing.
• Small banks: You’re less likely to find a credit-builder loan at national, big-name banks, but your community or regional bank may offer this product.
• Community Development Financial Institutions (CFDIs): These institutions, which include banks, credit unions and nonprofit funds, specialize in doing business with borrowers in underserved communities and low-income areas.
• Online lenders: Some online lenders offer credit-builder loans with loan terms as long as 48 months.

Who is a credit-builder loan for?

People new to credit, like recent high school or college graduates, may benefit from a credit-builder loan to help develop a credit score. Taking out a credit-builder loan could also be a wise move if you fit into one of the following categories:

Credit-invisible consumers

If you’re credit invisible — you don’t have any reported credit history — a credit-builder loan can help add a positive payment history to your reports so you can earn a credit score. In 2022, consulting firm Oliver Wyman conducted a study on behalf of credit bureau Experian and found that over 28 million U.S. consumers didn’t have any credit history.

Thin-credit consumers

A credit-builder loan could also help if you have a thin credit profile, which means you don’t have enough active credit history to generate a credit score. Once your payments are reported to the credit bureaus, it can beef up your credit file.

In addition to the 28 million credit-invisible consumers, an additional 21 million Americans are “unscorable.” These consumers have some experience with credit, but not enough to generate a score.

When to avoid a credit-builder loan

If you need emergency funding, a credit-builder loan won’t help. Because the funds are disbursed slowly and only amount to what you’ve already contributed, they won’t be able to help in a pinch.

Instead, you should research emergency loan options and alternatives. Avoid payday loans, which can have predatory interest rates as high as 400% and may trap you in a cycle of debt.

How to get a credit-builder loan in 6 steps

Getting a credit-builder loan is relatively easy — there are typically no credit checks involved, and you could get your account set up the same day you apply. That said, there are still a few steps to follow for you to get the most out of your loan.

1. Review your monthly budget

Don’t take on a new monthly payment unless you’ve checked your monthly spending. Remember, you don’t receive any funds upfront with a credit-builder loan. Start with a small loan amount to ensure you can afford the payment and avoid a situation where you can’t repay the balance.

2. Check your credit history

Although credit-builder loan eligibility criteria aren’t as focused on your credit scores, checking your credit history for any issues affecting your approval is a good idea. You can get a free weekly copy of your credit reports from Experian, TransUnion and Equifax by visiting AnnualCreditReport.com. Disputes may take up to 30 days to be addressed, so be sure to give yourself ample time between reviewing your report and applying.

3. Compare your options

It’s always best to shop around before you choose a credit-builder loan. You may get a better rate, more flexible repayment terms or lower costs by checking with multiple lenders. Pay attention to the following when comparing lenders that offer credit-builder loans:

• Loan amounts: Although the amounts vary from lender to lender, most credit-builder loans are between $300 and $1,000. The more you borrow, the higher your payment will be, so starting with a smaller loan is best.
• Repayment terms: Credit-builder loan terms tend to be shorter, from 12 months to 36 months. The shorter your term, the higher your monthly payment, but the lower interest you’ll pay overall.
• Flexibility: In general, you can’t access credit-builder loan funds until you’ve made all the payments. However, some lenders may allow you to receive some of the balance after you’ve made a set number of payments. Others may release money into your account after each monthly payment.
• APRs and fees: Your monthly payment may not cover interest and fee charges. In such cases, those costs are deducted after you’ve made all of your scheduled payments, which can take a big chunk out of the funds you receive.

4. Gather all the necessary information

Credit-builder lenders usually require the same documents needed for a personal loan. The requirements may vary among lenders, but usually include:

• A picture ID, like a driver’s license or passport
• Your Social Security number and date of birth
• Your phone number, address and email address
• Copies of paystubs, W-2s or tax returns to prove your income
• Employer contact information
• Your bank account number and routing number
• Proof of your monthly rent or mortgage payment

5. Apply

Once you’ve chosen the credit-builder lender you want to do business with and have your documents ready, you’ll fill out the lender’s full application. The process is typically all done online, and you can upload your financial paperwork through a secure portal on the lender’s website.

At this point, the lender will perform a hard credit pull and make a decision — and you’ll possibly receive an answer within seconds. If you’re approved, review the terms carefully and ask questions if you don’t understand how much you’ll pay each month, what the fees are or when you can access the loan funds.

6. Make payments and track your progress

Once you sign your final documents, you’ll begin making your monthly payments. Most credit-builder lenders set up automatic payments through your bank so you don’t miss a payment. If the lender offers a mobile app or online tracking option, use that to stay on top of your payment progress.

After you make payments for a few months, start tracking your credit score progress. Ask your lender if it offers a free credit monitoring service and enroll in it so you can keep watch for movement in your scores.

Other options for building credit

A credit-builder loan isn’t the only way to improve or build your credit score. There are many other credit-building options to consider, depending on your needs and timeline.

• Secured credit card: If you’re looking for ways to build credit, a secured credit card can be a valuable option. These types of credit cards require that you establish a savings account with the credit card issuer and maintain a certain balance. These funds act as security for the line of credit.
• Become an authorized user: If a parent, family member or spouse has a solid credit profile and a credit card account in good standing, ask if you can be added as an authorized user to the account. That individual’s credit history will then be added to your credit profile.
• Make bill payments on time: If you simply have a low credit score that you’re looking to improve, ensuring that you establish a consistent track record of paying all bills on time can help increase your score over time.
• Pay down existing debt: Yet another way to improve a low score is by focusing on paying down any existing debt you may have. Minimizing balances on credit cards and personal loans can go a long way toward improving a credit score. Credit experts generally recommend borrowing less than 30 percent of your available credit limits.

Bottom line

A credit-builder loan can be a helpful tool to build or improve your credit score if you’re new to credit. However, because you don’t receive all the funds until you’ve made all the payments, it’s important to pick an amount that won’t squeeze your budget. A credit-builder loan can be a stepping stone towards a stronger financial future if used responsibly.

Frequently asked questions about credit-builder loans

• Is a credit-builder loan a good idea?
  

  If you’re in a position to make on-time payments, the pros of using a credit-builder loan should outweigh the cons. However, if you can’t keep up with the payments, a credit-builder loan could do more harm than good.

• What is the best credit-builder loan?
  

  The answer depends on your specific needs. To find the best credit-builder loan for you, compare fees and loan terms from as many lenders as possible.

• Do you get the money upfront with a credit-builder loan?
  

  No, unlike a traditional loan, you can only access the funds after you’ve made the required number of payments. If you need immediate access to funds, a traditional personal loan or personal line of credit is likely a better solution.

• Should you use a personal loan to build credit?
  

  If you qualify, using a traditional personal loan to build credit could be an excellent alternative if you need funds right away and can comfortably afford the monthly payments. Before you do this, though, consider potential downsides like high borrowing costs and more debt.