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Key takeaways
- Credit-builder loans can help borrowers improve their payment history — and by extension their credit score — since they report regular, on-time payments to major credit bureaus.
- Benefits of credit-builder loans include flexible acceptance criteria, the chance to improve your credit and the ability to build savings.
- Potential downsides to credit-builder loans include a drop in your score if you don’t repay it on time, fees and no immediate access to your money.
Your credit score is among the main factors that help you qualify for credit and set your rates. If that number is below the good credit threshold, you might be stuck with high interest rates and expensive monthly payments.
One way to address this issue is through credit-builder loans. These loans are designed specifically for borrowers who want to raise their scores. However, they come with the same risks as any type of loan. Consider the benefits and drawbacks before applying.
Pros of credit-builder loans
A credit-builder loan is a way to show the major credit bureaus you can consistently make on-time payments. Doing so should improve your access to other financial products. Consider the advantages of credit-builder loans before you apply.
Can improve your credit
Most notably, credit-builder loans can improve your credit score. As you pay each month, those on-time payments are reported to credit bureaus. Payment history accounts for up to 35 percent of your score, and as that track record improves, your credit score likely will too.
Flexible acceptance
Due to the fact credit-builder loans are designed for those with low credit scores and little or no credit history, lenders have much more flexible borrowing eligibility requirements. Lenders will not require good credit but instead may request information on your income, employment history and balances for your savings and checking accounts. Even with laxer eligibility requirements, lenders still want to know you can afford payments.
Ability to build savings
Typically, when you take out a loan, you are borrowing money to pay for a significant expense. In this case, the lender holds onto the money and sends it to you once you’ve paid it off, minus any fees. You’re essentially saving money for later. Some lenders even put your money in a certificate of deposit account where it will earn interest, though it may not be enough to offset the annual percentage rate the lender charges.
Cons of credit-builder loans
Although credit-builder loans have upsides, all financial products come with their share of risks. Consider the downsides of credit-builder loans before you choose one over alternatives like secured credit cards.
Potential to drop credit score
As with any loan, a credit-builder loan has the potential to lower your credit score if you miss payments. Missing payments on a credit-builder loan can dramatically decrease your score and potentially put you in a more challenging financial spot.
Lenders can charge high fees
Interest rates and standard fees vary significantly among lenders. Some offer zero interest or fees and some may partially refund the interest when you pay off the loan. Others enforce steep fees that can significantly increase your expected monthly or overall cost. Common fees included prepayment penalties, origination or administrative fees and processing fees.
No immediate access to money
Credit-builder loans tend to carry repayment terms of up to 24 months, and access to the funds paid is not granted until after payoff. These loans are not appropriate for those who require fast access to cash, as you must fully repay the loan to get the money. If you’re looking for fast cash in an urgent situation, explore emergency loans instead.
Are credit-builder loans worth it?
While credit-builder loans are different from other types of personal loans that provide a line or credit or lump sum of cash, they can be well worth it for consumers who need help building credit.
Monique White of Self Financial, a credit-builder loan company, says these loans are best for consumers who are new to credit or someone who has been denied access to traditional financial products in the past.
“Credit can be a catch-22 because typically you need credit to build credit,” White says. “A credit-builder loan can open the door for someone to access credit by building positive credit history over time and gaining access to other credit products.”
While credit-building alternatives give borrowers a line of credit they can spend, credit-builder loans actually help consumers save. Unlike a typical loan where you receive the funds upfront, with a credit builder loan the funds are held in a CD and the consumer pays in monthly installments.
“Each payment is reported to the credit bureaus and builds credit history,” White explains. “At the end of term, the consumer can access the savings, minus interest and fees.”
At the end of the day, that makes credit-builder loans a form of “forced savings” that helps consumers build credit history along the way.
Bottom line
Taking out a credit-builder loan can be a great option for some borrowers, but they are not ideal for everyone. While they are an option for those with little history, these types of loans do not provide immediate access to funds and they may come with high fees.
If your main priority is to improve your score and you feel confident in your ability to pay off the loan, a credit-builder loan can be step one to achieving excellent credit. Be sure to research the options available to you before jumping into any financial commitment.
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