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Receiving credit approval can be tricky. It’s difficult for a borrower to qualify for loans and credit cards if they don’t have a good credit history. Creditors want proof that you don’t overspend and can pay your bills on time. If you don’t already have an established credit line, you may struggle to demonstrate that you’re a reliable borrower.

Luckily, borrowers can improve their credit scores through credit-builder loans. Keep reading to learn more about these loans and who should apply for one.

What is a credit-builder loan?

Community banks and credit unions sometimes offer credit-builder loans as a way to give borrowers a chance to show they can make regular payments to pay off a loan or debt. Ultimately, a credit-builder loan builds or rebuilds a positive credit history.

How credit-builder loans work

A credit-builder loan is a little different from a traditional loan. A lender holds money in a federally insured savings account. Every month, you pay the lender as though you are paying a credit card bill or loan, and your lender reports those payments to the credit bureaus. As long as you pay your credit-builder loan payments on time, your credit score should improve.

Unlike a traditional loan, the borrower doesn’t receive money at the loan closing. Instead, once the lender obtains the last payment, the borrower receives the funds.

How much is a credit-builder loan?

Since the objective of this loan process is to help the borrower establish a good credit history, terms and amounts are different from a traditional loan.

Lenders offer these loans in small amounts, such as $500 to $1,500. Some loans go as high as $5,000. You make payments over the term of the loan, which is typically one to two years.

Who needs a credit-builder loan?

People who are trying to establish credit or rebuild it after a major financial discrepancy, such as bankruptcy, may want to consider applying for a credit-builder loan. These loans also help people trying to build credit for the first time in their lives, such as recent college graduates, divorcés or immigrants.

For example, a recent college graduate who doesn’t have a credit card can use it to establish a positive credit history. After going through the credit-builder loan process and developing a good credit history, they may have an easier time renting an apartment or getting a mobile phone account. These types of first-time borrowers may see a bigger boost in their credit score than someone rebuilding their credit.

To qualify for this loan, you should have an income that allows you to make $50 to $100 monthly payments for the loan’s term. Unresolved financial judgments can make it more difficult to qualify. Make sure you pay outstanding debts before applying for a credit-builder loan.

The importance of credit history

Credit bureaus calculate your credit score based on several credit data points, including your credit history. In fact, your credit history makes up 35% of your entire score. It’s important to maintain a good credit history for your financial future.

Ultimately, applying for a credit-builder loan is a good way to establish credit. It may eventually lead you to qualify for other loans, such as a car loan. Credit-builder loans can also help you obtain future loans with lower interest rates.

Disclaimer: This story was originally published on June 1, 2022, on BetterCreditBlog.org. For more information on building your credit please visit: https://money.com/how-to-build-credit/.