Could a Credit-Builder Loan Be the Ticket to Improving Your Credit Score?

by Christy Bieber | Updated July 21, 2021 - First published on April 20, 2021

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Should you apply for a credit-builder loan if you don't have great credit?

Trying to build credit can be a challenge. This is especially true if you have no credit history or bad credit and can't get a loan. Your payment history is one of the most important components of your credit score. If you can't get approved to borrow, you can't improve your score and show that you'll be responsible for repaying your debts.

There are a few different ways to gain access to credit so you can start showing lenders you can be trusted. One of the best options, though, is a credit-builder loan. Here's why.

What is a credit-builder loan and how does it help you improve your credit score?

Credit unions and some banks offer credit-builder loans. They work differently than traditional personal loans.

With a traditional loan, you get the money up front from a lender after you've been approved to borrow. Once you have the money, then you start making monthly payments to your lender. You pay back the principal (amount borrowed) as well as interest accrued on the loan. But if you don't repay the entire amount, the lender is out the money and has to try to collect.

Lenders don't like to give traditional loans to people with bad credit or no credit because they think the risk that you won't pay is too high.

A credit-builder loan, however, involves a different process. You'll apply for the loan, and you'll start making payments on it after approval. However, you will not get the borrowed money up front. Instead, it's deposited by the lender into a bank account under their control.

Once you've made the full payments due on the loan, then you'll be given access to the funds you borrowed. In other words, you're getting approved for a loan first but you're paying it off before you get the proceeds.

This type of loan doesn't work well when you actually need to borrow money to fund a purchase you can't afford. But it's ideal for building credit because you're developing a positive payment history; the loans are easy to get approved for since the lender isn't taking any risk; and you're saving money in the process.

Credit-builder loans can be a good alternative to secured credit cards. You aren't tying up money indefinitely, as you would when you put down cash as collateral to guarantee a secured card. Once you're done paying the credit-builder loan, you get the money you paid in. You can use that money for anything you want, including moving it into an emergency fund or a savings account earmarked for big purchases.

Credit-builder loans are also reported to credit bureaus and show up on your credit history as installment loans. Credit cards, on the other hand, are revolving debt. It's good to have a mix of different kinds of loans on your credit report so lenders can see you pay off various types of debt responsibly.

If you're trying to build credit, see if your local credit union or community bank offers a credit-builder loan. If they do, consider applying for one. It can help you get on the path to earning a credit score that can open all kinds of doors for you.

And for more options, take a look at our resources to help you increase your credit score.

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