What Is a Credit-Builder Loan?
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Credit-builder loans are a tool for people with weak credit profiles to establish payment history.
They’re small loans offered by banks, credit unions and online lenders, designed for people with limited credit or no history at all.
As a result, these loans have extra protections for lenders. Most notably, you don't get access to the loan amount upfront. Instead, you have to make monthly payments first, and once you've essentially paid off that amount, you'll get the lump sum.
How do credit-builder loans work?
When you take out a credit-builder loan, your lender will move the loan amount (usually $300 to $1,000) into a locked savings account.
Like a traditional loan, credit-builder loans require that you make a fixed monthly payment to the lender, and this monthly payment includes an interest rate, or the loan’s annual percentage rate (APR).
Say you take out a $600 credit builder loan for one year with a 10% APR. Your monthly payment would come out to $52.75 ($50 principal, plus interest).
After 12 months, you’ll get that $600 you’ve saved, and you’ll have a year of positive payment history that’s been reported to the major credit bureaus. With some lenders, you may also get to keep a portion of the interest.
Credit-builder loans are not usually offered by the biggest banks, so you may have to look around to find them. Your options may include community banks and credit unions as well as online lenders.
Loan terms are typically between 6 months and 24 months, according to the Consumer Financial Protection Bureau (CFPB).
Because credit-builder loans are secured, the lender can simply close the account if a borrower stops paying. According to the CFPB, “borrowers are protected in the sense that they cannot end up with a lasting outstanding balance.”
How much does a credit-builder loan cost?
The main cost of a credit-builder loan is the interest, which borrowers pay on a monthly basis. Lenders are currently advertising rates online ranging from 5% to 15% or more.
If you’re planning to open a credit-builder loan, it’s a good idea to compare several options to find the best rate.
In addition to interest, credit-builder loans could have origination fees attached to them. There may also be payment processing fees and late fees, depending on the loan.
Are credit-builder loans worth it?
Credit-builder loans can be effective, especially for people who need to build credit from scratch. If you’re trying to repair bad credit after a major financial discrepancy, such as bankruptcy, you may also want to consider a credit-builder loan.
When you make on-time payments for a credit-builder loan, that history will get reported to the three major credit reporting agencies (Equifax, Experian and TransUnion). Within a few months, you should start to see your credit score go up.
Creditors want proof that you don’t overspend and can pay your bills on time, and if you don’t already have an established credit line, you may struggle to demonstrate that you’re a reliable borrower. That’s where credit-builder loans come in. Payment history makes up 35% of your FICO score, so making on-time credit-builder loan payments can get you on track to qualifying for better loans and financial products with lower rates.
Risks of a credit-builder loan
The biggest risk of a credit-builder loan is the consequences of missing payments. If you don’t pay your loan on time, your credit score could take a hit, just as if you miss any other type of loan payment.
Also, if you’re paying off debts, that should be your top priority. Instead of adding a monthly payment for a credit-builder loan, consider focusing on your debts.
Credit cards vs. credit-builder loans
Credit-builder loans are not the only way to improve your credit. While credit cards have their own risks, many people opt to begin their credit journeys with an intro credit card (like a secured credit card) rather than a loan product.
Opening a credit card and managing it responsibly — meaning not using more than 30% of your credit limit and paying any balance in full each month — is also an effective way to start building credit if you don’t want to take on any loan obligations.