What Is a Credit Builder Loan? [Explanation & Alternatives]

Do you have a bad credit history or no credit history at all? This concise guide will explain everything you need to know about these loans and help you learn how to build credit.

What we covered what is a credit builder loan, how does it work, how to get one, its pros and cons, and more.

How Do These Loans Work and How Can They Help Your Credit Score

Before you go any further, what is a bad credit score? It’s any FICO score below 670. If you’re not sure what score you have, perhaps you should check it to find out whether yours is good, fair, or poor.

Credit builder loans can help anyone who has no credit history or little credit history to establish credit. You aren’t required to have a good credit score in order to be approved for this type of loan, but only to have a high enough income to cover each monthly payment.

You’ll benefit most from applying for this loan if you don’t have any credit history. If you’re already in debt, you might need to search for personal loans for bad credit.

With this kind of loan, lenders don’t give you the money right away. After you agree on a certain amount and pay it off entirely, you’ll get the money. Since lenders manage the funds, they don’t risk too much, and they offer loans to individuals who have bad credit scores or no credit score whatsoever.

Once you get approved for the loan, the money you borrowed stays in a bank account until you pay off the loan. So, you cannot use that money until you make all the monthly payments. You’ll be making savings and building your credit, which is the whole point of this type of loan.

When you get the loan, lenders will put that in the report, which is sent to the three main credit bureaus (Experian, TransUnion, and Equifax).

These loans are small, usually around $1,000 or less, and the sole purpose is to establish a credit history.

While these loans aren’t that common, there are banks that offer credit builder loans.

Payment history makes up about 35% of your FICO credit score. And paying on time is paramount once you get a credit builder loan because it demonstrates your ability to handle a credit account. FICO score and VantageScore, which are the most commonly used credit scoring models, look at your payment history to establish your credit score, so paying every month can help you have a better credit report.

Different Types of Loans 

There are two kinds of credit builder loans: pure and share secured loans.

Pure Builder Loan

If you were wondering how to build credit, this type of credit-building loan is an excellent way to build a savings account while improving your credit score simultaneously. Here’s how it works. The lender places the whole loan amount in a savings account, and you’ll not be able to touch it until you pay off the entire sum. Some other loans require you to pay the initial deposit, but that’s not the case with this one. The only thing you have to do is to make monthly payments.

After you repay the loan, the money will be at your disposal, and you can do whatever you want with it. What’s more, the information about your successful payment history will be noted in your credit report, and your credit score will go up.

Share Secured Loan

This type of credit builder loan utilizes a savings account as collateral. As a borrower, you have to deposit some amount of money into a savings account, and then the lender will freeze the funds. Once you pay off the loan, a sum of money equivalent to the amount on your account will become available.

This kind of loan can be useful for someone who wants to improve their credit mix, which is one factor that is calculated in your credit score. It won’t improve your credit score a lot, but it may make a difference between a good and a fair credit score.

Once you pay back the loan, banks or other lenders will be more confident with lending you money because you showed that you can make your monthly payments on time.

In a nutshell, these loans can be useful for anyone who wants to establish a credit history or for individuals who have bad credit and who wish to mend their score.

What to Consider When Looking for This Type of Loan

As with any other loans, you should know what to look for in credit building loans. Some lenders have high fees, so let’s find out about them.

Administrative Fee

This fee is usually paid before even qualifying for a loan. In some cases, it can be from $9 to $25.

Loan Amount

The usual amount is $1,000, but it can be lower.

Monthly Payment

Before you ask for a loan, think about the amount you need because the higher the loan, the higher the monthly payment.

Annual Percentage Rate (APR)

credit-builder loan lenders charge interest and fees, and the APR is their interest rate. APRs for these loans are generally in the range of 5% to 16%, and your creditworthiness and lender’s rate are taken into account when calculating APR.

Interest Rates

There are cases when lenders or banks pay back some of the interest you paid, but only if you made all the payments on time. Also, the longer the term is, the more interest you’ll pay.

Loan Repayment Term

These loans have a repayment term ranging from 6 to 24 months.

Late Fee

If credit builders don’t pay on time, they’ll have to pay a late fee, which varies from lender to lender.

Step-By-Step Guide to Getting These Types of Loans

Here’s what you need to do to get a loan:

1. Find who is offering them. Aside from credit unions and banks, you can find online lenders who offer credit-builder loans. Double-check if lenders report your payment history to the credit bureaus.
2. Determine how much you need. Usually, people ask between $300 and $1,000.
3. Compare offers from different lenders. To find the best option for yourself, research a number of lenders because sometimes they can have different fees, monthly payment amounts, and repayment periods. Most importantly, their interest rates can vary a lot.
4. Apply for a loan. Applying for this type of loan is easy. You’ll have to give your name and address and other contact information. What’s different when applying for a credit-building loan is that your bad credit score isn’t a disadvantage, and you’ll be able to get the loan regardless of your credit history.

How to Handle This Loan

Were you wondering, how to improve my credit score? Read the next part and learn what steps you can take to do that.

Choose the Type of Loan

Apply for a credit-builder loan with the amount of monthly payment you think you’ll be able to afford. If you’re not sure that you can handle payments, perhaps you should think it over because paying late can lower your score. It’s wise to choose a loan with an affordable amount and repayment term that isn’t longer than 2 years. Also, find a lender that sends reports to all three major credit bureaus.

Pay in a Timely Fashion

As long as you pay every month on time, your credit report will be better than before you used credit building services. However, if it happens that you missed paying for one whole month, that information will go into your credit report, and it will decrease your score significantly.

You Can Check Your Credit Score

Find a website where you can check your credit score and where you can observe how it’s increasing.

Think About What You’ll Do With the Loan

After you repay the loan in full, you’ll receive the money on your credit-builder account. The loan amount isn’t big, but it can do a lot for you in some emergency cases.

What Will Happen After You Pay Off The Loan

After you finish with all your monthly payments, the lender will unfreeze the money on your account. Besides, some lenders will repay the interest that you were paying, excluding the fees. Having this in mind, explore what fees, policies, and interest rates they offer on their websites when looking for loans to help build credit.

What Happens if You Miss a Payment

Building credit using these loans can be a very convenient way to improve your credit score, but not paying on time can have serious consequences. Namely, lenders will report that you missed a payment to one or all three major credit bureaus, which will very likely decrease your score.

What if I Pay Off the Loan Earlier Than Agreed

More often than not, credit builder loan companies will allow you to pay back a loan earlier than you are supposed to, but by doing that, you’ll minimize the loan’s effects. If you pay off earlier than agreed, your payment history won’t change much or at all. Since the whole purpose of this loan is to build a credit score if you didn’t have credit before or to improve it if you had a poor score, this might not be a good choice.

Bear in mind that there are more consequences than just not having your score improved. Especially if your money is in a certificate of deposit (CD). If you pay back the loan earlier than the loan term, you’ll have to wait to close down the CD and withdraw your funds. What’s more, you’ll be obligated to pay a prepayment penalty.

To sum up, if you’ve applied for some of the credit building loans for bad credit with the idea to improve your score, we advise you to commit to the monthly payments as per your loan term and not to pay off ahead of time.

Can You Earn Interest?

After learning what a credit builder loan is and how it works, it’s time to find out about the interest. Some lenders put your money in a CD or savings account while you’re making payments each month. Once you finish paying, the amount becomes available to you. In theory, you can earn interest with these loans, but the rate you earn is much lower than the one you’re paying on the loan.

For instance, you can have a loan in a certificate of deposit where you can earn more than 1% interest. However, the interest rate you are going to pay on a loan can be around 15%. So, these earnings won’t be more than a few bucks, while the fees and interest rate will be much more than that.

Where You Can Obtain These Types of Loans

There are multiple options for you to get a small loan to build credit. Here’s where you can apply for one:

Online Lenders 

First, you can try to find credit-building loans online. They all have different monthly payment amounts depending on the loan amount you need. The interest rates vary, as there are some lenders that don’t charge them, but some do. If you research a bit, you’ll find some great credit repair companies on the internet.

Community Development Financial Institution 

If you can’t find this type of loan online, you can try with CDFIs. These institutions are dedicated to helping people with lower income get loans and other types of financial assistance, and there are lots of them in the US.

Community Banks or Credit Unions

In case you are more comfortable asking for a credit builder loan from a credit union or community bank, don’t worry. You have that option as well. You usually have to meet certain membership requirements, for example, to work for a specific organization or reside in a specific county. It’s likely that they offer lower interest rates, so you should explore this option and see if you’re eligible.

Alternatives to This Kind of Loan

If the options that we outlined in our guide don’t work for you, there are a few alternative ways of getting better credit:

Become an authorized user on someone else’s credit card

You can ask a family member or friend who has an impeccable credit score to add you as an authorized user. By doing this, the good payment history of that card will show on your credit report as well. You don’t need to carry the card with you or to spend any money from it. Your association with the card is enough.

Certificate secured loan

If you already have funds deposited in the bank, you can ask for a certificate secured loan to build credit. The deposit in the bank can serve as collateral, and this money will be out of your reach until you repay the loan.

Unsecured personal loan

If you are looking for loans to improve credit, you can apply for an unsecured personal loan. If you use this option, lenders don’t have collateral, just your credit history. And, if your credit history isn’t that good, you’ll have to pay higher interest rates. Sometimes they can be quite high, so think about it and decide if this is a way to go for you.

There are lenders who offer credit builder loans and no credit check is performed. Additionally, certain lenders won’t send information about your payment history to credit bureaus, that’s why you should inform yourself on what affects your credit score and take it from there.

Pros and Cons

Wrap Up

We hope that now it’s clearer how these loans work because they can be very helpful. So, if you have no credit history at all, or a bad credit score, this type of loan is perfect for you. A good alternative to fixing your credit score could be restoration services such as those Credit Saint provides.

The payment activity you demonstrate when making monthly payments is sent to the credit bureaus. Since your credit score consists of information on the credit reports that the three main credit bureaus create, letting them know that you’re a good payer boosts your credit score. Just remember that sending information about your monthly payments can only help you improve your credit as long as you pay on time.

With that fact in mind, you’ll be able to rebuild your score and save money for something you want to buy in the future.