What Is a Credit-Builder Loan and How Do I Get One?

Good credit can open up many opportunities, like low mortgage rates, great credit cards, and more. A credit-builder loan can help you move toward a good credit score, but it's one of the more expensive ways to build credit. Here, we'll cover the ins and outs of credit-builder loans -- and alternatives worth considering.

What is a credit-builder loan?

A credit-builder loan is a loan that can help you boost your credit score. This type of loan has one major difference from traditional loans: You won't get the money from a credit-builder loan until after you've paid off the loan completely.

Credit-builder loans can be helpful for people who have damaged credit or no credit history. However, because you still need to pay interest, credit-builder loans tend to be one of the more expensive ways to build credit. Make sure you consider all your options before deciding to go with a credit-builder loan.

Alternatives to a credit-builder loan

Secured credit cards, becoming an authorized user on someone else's credit card, personal loans with a cosigner, and many other methods can also help you build a credit history.

Secured credit card

With most secured credit cards, you'll pay no interest if you pay your bill on-time.

You can get a secured credit card with low or no credit. With a secured credit card, your regular payments are reported to the credit bureaus. This gives you a chance to build a credit history.

Here's how a secured credit card works:

1. Make a deposit to the credit card issuer. Usually, the amount you deposit becomes your credit limit. If you want a $500 limit, you'd usually deposit $500. The issuer keeps this money in a savings account while you have the card.
2. You charge the card and make payments, just as you would with a traditional credit card.
3. Over time, you should see your credit score increase. When you're ready to move to a new credit card, the issuer refunds your initial deposit.

Browse our top picks for secured credit cards to get started with a secured card.

One caveat: Be careful of the hidden fees and high interest rates charged by some secured credit card issuers. This is not a good option if you will struggle to pay your bill each month.

Authorized user on someone else's credit card

Becoming an authorized user on someone else's credit card is simple. You can become an authorized user with no credit or poor credit. Payments on the card will be reported to the credit bureaus, improving your score. And again, if you pay your bill on-time, you usually won't pay any interest fees.

Be careful with this method, though: The primary cardholder's activity can also affect your credit score. In some cases, if the primary cardholder is irresponsible, they could drag your credit score down.

To become an authorized user, read our guide to adding an authorized user to a credit card.

Personal loans with a cosigner

If you have bad credit or no credit, you can usually still get a personal loan with a cosigner. Often, you can get a lower interest rate with your cosigner than you would get on a credit-builder loan. You'll also receive your loan funds right away (instead of after the loan is paid off).

When you have a cosigner with excellent credit, a lender considers the strength of their credit score rather than the weakness of yours. Your on-time monthly payments are still reported to the credit bureaus, which improves your score.

If you're thinking of opening a personal loan with a cosigner, start by checking out our list of best personal loans.

How does a credit-builder loan work?

Credit-building loans are a little different from other loans. Here's how they work:

• You apply for a credit-builder loan (and you're approved).
• Instead of sending you the money you're borrowing, the lender puts these funds into an account that you can't access.
• You make a monthly payment.
• Each time you make a monthly payment, the lender reports it to credit bureaus. Then, it goes on your credit report.
• This builds a solid payment history, which raises your credit score.
• After a specific number of payments (typically 12 or 18), the credit-builder loan is paid in full. The lender releases the funds to you after your last loan payment. If you have a savings account, the lender may be able to deposit the loan funds directly into your account.
• You spend the money however you want.

It's important to note that you don't just repay the amount of money you applied to borrow. You'll pay interest every month, too. You might also pay possibly a small administrative fee. Be sure to ask about fees before signing up for a credit-builder loan.

What is the difference between a credit-builder loan and a personal loan?

When you take out a personal loan, the money you're borrowing is sent to you shortly after you sign the loan papers. That's not the case with a credit-builder loan. A credit-builder loan requires you to pay the loan off in full before you get any money from the lender.

Because of your limited (or damaged) credit history, the lender wants to be sure that you're going to pay the loan before they hand the money over. But this isn't a bad thing. It's good for your credit -- each time the lender reports an on-time payment to the credit bureau, your credit history becomes a little rosier.

If you need money right away, you may want to consider a personal loan for fair or average credit instead. If your credit score is extremely low, try a personal loan for bad credit. If you want to build your credit history, but you don't like the idea of a credit-builder loan, you might want to look into alternatives like secured credit cards or a cosigned personal loan.

Where to find credit-builder loans

Credit-builder loans are available through some banks, online lenders, and credit unions. Here's a sampling of where credit-builder loans are available and what they offer:

• Alltru Credit Union: Alltru's rates aren't the lowest. However, they'll refund part of your interest payments at the end of your loan. They also offer smaller loans than some other lenders.
• Financial Partners Credit Union: Financial Partners Credit Union offers impressively low interest rates for their credit-builder loans. Loan amounts are offered in a healthy range, so you should be able to find something to fit your situation whether you want a large or small loan.
• Republic Bank: If your budget is especially tight, Republic Bank might be a good fit for you. They offer long loan terms and competitive interest rates, which translates to lower monthly payments.

How to manage a credit-builder loan

Managing a credit-builder loan doesn't have to be difficult. Here are three helpful tips for making a credit-builder loan work for you:

1. Understand the credit-builder loan you are considering. If you have any questions, ask before signing on the dotted line.
2. Only borrow as much as you can afford. In other words, if you can only afford to make a payment of $200/month, don't agree to monthly payments that are higher than $200/month.
3. Make all your payments on time and in full. You can sign up for autopay through your lender to make this step easier.

Your credit score impacts everything from the interest rate you pay on a loan to whether you can rent a home or land the job of your dreams. Whether you're just starting out or starting over, a credit-builder loan is worth consideration if you need to increase your credit score.