What Is a Credit Builder Loan and How Does It Work?

Credit-builder loans help people with limited or no credit history establish or improve their credit scores. Unlike traditional loans, credit-builder loans do not advance funds to borrowers to consolidate debt or make a significant purchase. Instead, they allow borrowers to make regular payments, which the lender reports to the credit bureaus. If borrowers maintain the payment schedule, their credit scores can improve, helping them qualify for future loans.

How does a credit builder loan work?

With a traditional loan, borrowers receive funds upfront and pay the loan back with interest over the loan’s duration. Credit builder loans require borrowers to make payments before accessing the funds. When a credit builder loan is activated, the lender usually places the loan amount into a locked savings account, and the borrower makes monthly principal and interest payments, typically over a term of six to 24 months.

The lender reports the payment activity to the credit bureaus, strengthening the borrower’s credit profile. At the end of the loan’s term or incrementally, the lender releases the loan amount, minus fees and interest paid, to the borrower. Some lenders return a portion of the interest if the borrower pays the loan as scheduled.

Who is a credit-builder loan for?

Research by the Consumer Financial Protection Bureau (CFPB) found that 45 million adults in the U.S. are either credit invisible (no credit record) or have no credit score because their credit history is limited or too out of date. Credit-builder loans are meant to serve that segment of the population. They give people with poor or no credit scores the opportunity to establish enough credit to apply for credit cards, car loans, or other lending services.

The following groups of people are more likely to need credit builder loans.

Young adults

Young adults with no credit history often need to establish a credit profile before applying for certain credit products, such as a car loan, mortgage, or unsecured credit card.

Immigrants

People new to the U.S. credit system will likely not have a credit history or score.

African Americans, Hispanics, and Native Americans

In recent years, surveys by Credit Sesame and the Urban Institute have found that African Americans and Hispanics are more likely to be credit invisible or have low credit scores. According to the latter, Native Americans also have low median credit scores.

People with low incomes

People with low incomes, particularly those living in low-income neighborhoods, tend to be credit invisible or have lower credit scores than people with higher incomes.

Where to get a credit builder loan?

Consumers can find credit-builder loans through various online banks and fintechs specializing in these loans, as well as some community banks and credit unions.

Requirements to consider for a credit builder loan

Loan size

The loan size, term, and interest rate determine the monthly payment. Larger loan sizes will have a more significant impact on credit scores but will increase monthly payments. Borrowers should choose a loan size that is comfortably within their repayment capabilities.

Repayment term

Credit builder loan repayment terms typically range from six to 24 months. Longer-term loans are better for improving your credit score but can tie up your money longer.

Monthly payment amount

Borrowers should choose a credit builder loan with a comfortable monthly payment amount. Lenders derive the payment amount from the loan size, repayment term, and interest amount.

Annual percentage rate (APR)

Lenders charge an annual percentage rate (APR) on the loan. This is the primary way the lender makes money. The higher the APR, the higher the monthly payment amount.

Fees

Credit-builder loan providers may charge administration and origination fees and make borrowers pay extra for late payments, payouts, or early loan closure. Pricing plans vary, so check with multiple providers to find the best plan for your situation.

Credit agency reporting

Lenders can report payments to one or more credit agencies. It’s a good idea to confirm with the lender which agency or agencies it reports to before you take out a loan. Ideally, the lender will report to all three major credit bureaus: Experian, TransUnion, and Equifax.

Personal credit behavior

People with a history of missed credit payments or bad credit habits should only pursue a credit builder loan if they are ready and capable of change. Credit builder loans can also damage credit if payments are late or missed.

How much does a credit builder loan cost?

Credit builder loan providers vary in how they charge customers. Most charge interest on the borrowed amount, and some may add an origination or administration fee, depending on the loan size. Interest rates typically range from 5% to 16% or more.

Only work with lenders that are 100% transparent with fees. Calculate and understand the total loan cost before proceeding.

How much does a credit builder loan help raise your credit score?

A 2020 study conducted by the CFPB found that borrowers with no existing debt were the biggest beneficiaries of credit-building loans. These loans allowed them to increase their credit scores by up to 60 points.

However, not everyone benefited. The study found that people who already had debt and credit scores sometimes ended up with a worse score after the credit building loan. Late payments were an issue. According to the CFPB, 39% of participants who opened a credit builder loan failed to keep up with repayments. In several cases, the credit building loan caused them to also be late making payments on regular loans.

Credit builder loan borrowers with little or no credit history who successfully make loan payments on schedule should see modest improvements in credit scores. However, missed or late payments may reduce or eliminate the benefits of a credit-builder loan.

How to get a credit-builder loan

Borrowers can inquire with community banks or search online for banks and credit unions that offer credit builder loans. Many allow online applications. An existing credit score is usually not a requirement to apply. However, lenders will ask for the following information:

• Identification.
• Contact information.
• Employment information.
• Housing costs information.
• Existing loan or credit card details.
• Income verification (W-2s, bank statements).

Essential tips for managing a credit builder loan

Commit

The point of getting a credit-builder loan is to establish a credit profile or increase your credit score. The loan may have the opposite effect if a borrower is not committed to paying the monthly payment. Only enter into a credit builder loan agreement if you are fully committed, have a secure and predictable income source, and have enough monthly cash flow to cover the payment.

Automate payments

Set up automated transfers to ensure you never miss a monthly payment.

Set aside the entire loan amount

If you have sufficient funds, set aside enough cash to cover the total loan payments and draw down the isolated funds to pay off the loan. This will allow for reliable automated payments and reduce the risk of missing a payment.

Should you use a personal loan to build credit?

Consumers have multiple ways to establish and build credit. Credit builder loans are a type of personal loan that may be appropriate for people who cannot get approved for credit cards. If a consumer has the need or desire to establish credit and cannot access entry-level credit cards, personal loans can help.

Pros and cons of credit-builder loans

Alternatives to credit-builder loans

Credit cards

Credit cards are a common way to establish credit. Card companies often market credit cards to college students, who use them to spend and begin building a credit profile. College students often carry debt until graduation and pay it off when they start earning from their first jobs. Though going into debt in college can establish bad habits, responsible credit card use by young adults will establish credit for more substantial borrowing later on.

Secured credit cards

People who do not qualify for an entry-level credit card could consider secured credit cards. These cards require a refundable deposit, which becomes the credit limit. Cardholders then spend with their card and pay the balance each month.

The card issuer reports payments to the credit bureaus, helping to establish and strengthen credit profiles. The deposit secures the card limit, reducing the card issuer’s risk and making it easier for the customer to qualify.

Authorized user

People without a credit history can ask a family member with good credit to add them as authorized users to their existing accounts. The primary user's positive payment history will appear on the authorized user's credit report, thus increasing their credit score. Establish agreed-upon spending and payment guidelines to ensure both parties are on the same page before moving forward with an authorized affiliation. Miscommunication or misbehavior can lead to damaged credit scores and relationships.

TIME Stamp: Credit building for creditworthiness

Credit builder loans help individuals with limited credit histories establish and enhance their credit scores. When borrowers make timely payments, these loans can improve their credit profiles. However, they can also be dangerous and counterproductive. Research shows that people who take out these loans often fail to make payments on time, damaging the credit score they are trying to establish or improve.

Borrowers interested in credit builder loans should check with several loan providers to find the best fit. They should also be careful when choosing the loan amount and ensure they can comfortably meet the monthly payments before signing the dotted line.

Consider alternatives to credit builder loans, such as becoming an authorized user on another person's credit account or applying for a secured credit card.

Frequently asked questions (FAQs)

Can I get credit builder loans with no credit check?

Lenders will generally check your credit before accepting your application for a credit builder loan. However, they usually do not require a “hard” credit check, which looks at past credit and payment history and can impact your credit profile. Since many credit builder loan applicants have a limited history, lenders generally execute a "soft” credit check instead, which is slightly less in-depth and does not impact your credit score.

What differentiates credit builder loans from traditional loans?

Credit builder loans are designed to improve credit profiles, while traditional loans allow you to make an immediate purchase. A traditional loan provides funds into your bank account at the start of the loan, which you then pay back over the loan term. Credit builder loans go into a locked savings account at the onset of the loan, and the lender releases funds incrementally as payments are made or all at once when the loan is paid off.

Can you be denied a credit builder loan?

Yes. Borrowers can be declined for various reasons, including insufficient income, providing inaccurate information, or negative marks on their bank records or credit reports, such as bounced checks, bankruptcies, or foreclosures. However, qualification thresholds are low since these loans serve people with little or no credit history, and the lender usually holds the money until the loan matures.