If your financial history includes a few missteps or if you don’t have much credit history yet, credit-builder loans might be able to help. These loans are geared toward borrowers who are seeking to build their credit and who might not get approved for traditional loans from banks and other lenders.
Here’s a closer look at credit-builder loans and how to tell if they’re right for you.
How does a credit-builder loan work?
A credit-builder loan works exactly like its name indicates: It’s a loan that can help build your credit. But it operates a bit differently from a traditional loan.
While a traditional loan provides access to a lump sum of money right away, a credit-builder loan deposits the funds into an account and releases the money once you finish making all payments on the loan. So instead of using the loan to cover costs like debt consolidation, it instead helps you build a habit of making on-time payments.
Like traditional loans, however, credit-builder loans do include interest and fees, but these vary by lender. These loans also tend to be small — typically ranging from $300 to $2,000 with repayment terms from six months to two years, depending on the lender.
How credit-builder loans help your credit
Lenders that offer credit-builder loans will report your payments to at least one of the three credit bureaus — Equifax, Transunion and Experian.
Because your payment history is the largest component of your credit score, making on-time payments on a credit-builder loan can help to boost your credit over time. This in turn will show future lenders that you work with that you’re responsible with credit.
Pros and cons of a credit-builder loan
Credit-builder loans can be good for those who want to boost their credit but don’t have a lot of resources available to do so. However, they also come with some downsides.
Here are some pros and cons to consider before taking out a credit-builder loan:
| Pros | Cons |
|---|---|
|
|
Is a credit-builder loan a good idea?
While credit-builder loans can help you build or boost your credit score, they’re not the right fit for everyone. Here are some situations where getting a credit-builder loan can be a good idea:
- You have the regular income to consistently make on-time payments.
- You don’t have any credit history to your name or it’s very sparse (also known as having “thin credit” or as being “credit invisible”).
- You want to apply for other installment loans or revolving credit lines (like credit cards or lines of credit), but you don’t have the credit to qualify for them.
On the other hand, you might want to skip a credit-builder loan if:
- You’re eligible for other loan products that will better suit your needs, such as a traditional personal loan.
- You can’t afford to make regular payments.
- You need to build up your credit within the next couple of months, not necessarily over the year or more that a credit-builder loan could take.
How to get a credit-builder loan
- Find lenders. Not every lender offers credit-builder loans, so you’ll need to research and find potential lenders. Typically, credit-builder loans are provided by smaller lenders, such as online lenders, credit unions and community banks.
- Compare options. Once you’ve found some lenders, compare your options with as many of them as possible to find the best deal. Consider factors like interest rates, fees and eligibility criteria, and also check which credit bureaus your payments will be reported to. Some lenders allow you to pre-qualify to see if you’re eligible for a credit-builder loan, which only requires a soft credit check that won’t hurt your credit score. This will let you see what rate and terms you could get approved for if you apply.
- Pick a lender and complete an application. Once you’ve vetted several lenders, choose the loan option that best suits your needs. You’ll then need to complete a formal application. Be prepared to provide personal and financial information, including income and employment details. Also note that applying might require a hard credit check that could cause your credit score to drop by a few points. However, this impact is usually only temporary.
- Make a deposit and get funds. If you’re approved, you’ll begin making monthly payments according to your loan agreement. While some lenders give you access to a portion of your funds as you enter repayment, others require you to repay the loan in full before you have access to funds.
Alternative ways to build your credit
While a credit-builder loan is a good step if you don’t have any credit history, there are other ways to give your score a boost. Here are some alternatives to look into:
Get a secured credit card
Secured credit cards give you access to a small amount of money after you’ve made a deposit that serves as collateral. This deposit acts as your credit limit — for example, if you put $500 down, you’ll have a $500 credit card limit.
When you make payments on your card for what you’ve used, you’ll free up more money to use. On-time payments will also help you build a positive payment history. After a period of on-time payments, some lenders will allow you to convert your secured credit card to an unsecured one, and you’ll get your deposit back.
Become an authorized user
If you have a parent, relative or trusted friend with strong credit, they can add you to their credit card as an authorized user. The credit card account will be added to your credit report, and you can benefit from the primary account holder’s good credit habits. This can ultimately improve your credit score without you even needing to use the card.
Tip: If you’re an authorized user, you’ll likely receive a credit card in your name, which will allow you to practice responsible credit card use. However, make sure that you and the account holder have guidelines in place in case something happens— for example, if you use the card and can’t pay the balance in full or if you’re late making a payment.
While you’ll be able to take advantage of the original account holder’s strong credit history, poor credit usage will cause damage to your credit as well as theirs — so be sure to use the card wisely, if at all.
Get a personal loan
Personal loans can be used for almost any personal expense. While most personal loans are unsecured, some lenders also offer secured personal loans that require collateral. Because this reduces the risk for lenders, secured personal loans can be easier to qualify for, and they can have lower interest rates than unsecured loans.
Unsecured personal loans, on the other hand, tend to have more stringent requirements. You’ll typically need good to excellent credit to qualify for an unsecured loan. There are also some lenders that offer unsecured loans for poor or fair credit, though these tend to have higher interest rates than good credit loans. Bad credit loans can also come with more fees.
Regardless of whether you choose a secured or unsecured loan, it can help to build your credit history if you make on-time payments throughout your repayment term.
Find a co-signer or joint applicant
If you have a partner, parent or another trusted adult in your life who has good credit, consider asking them to be a co-signer or joint applicant on a loan with you. A co-signer signs onto the loan with you and agrees to be responsible for the loan if you as the primary borrower fail to make your payments. A joint applicant, on the other hand, shares equal responsibility for the loan from the start of the repayment term.
Having a creditworthy co-signer or joint applicant can make it easier to get approved for a loan, and it could also help you qualify for better rates or terms. However, keep in mind that if you fall behind on payments, your credit will suffer — and so will that of your co-signer or joint applicant.
Pay down your debt
Bad credit can be the result of racking up outstanding debt and struggling with payments. While this can be an overwhelming situation, there are several strategies that can help you pay off your debt and fix your credit.
For example, you can use the debt avalanche or debt snowball methods to tackle your debt. Or you could reach out to your creditor to see if a payment plan is an option. You might also consider signing up for a debt management plan with the help of a credit counselor.
Frequently asked questions (FAQs)
Credit-builder loan amounts are generally small — typically $2,000 or less, depending on the lender.
Credit-builder loans can be good for your credit score as long as you make on-time payments and the lender reports your credit usage to the credit bureaus.
Yes, you can pay off a credit-builder loan early if you prefer. However, keep in mind that this will reduce the number of on-time payments reported to the credit bureaus. This means you won’t build as much credit by paying off the loan early as you could by making all of your monthly payments over the repayment term.
