Published in: Personal Loans | Aug. 17, 2019

How Does a Credit Builder Loan Work?


Yes, you can build credit without credit cards or a co-signer.

credit score on screen

Image source: Getty Images

Almost no one makes it through life without needing to call upon credit at one point or another. But the Catch-22 is that it's difficult to find lenders willing to help you build a credit history when you don't already have one -- difficult, but not impossible.

A credit builder loan is a small loan you take out with the specific intention of building your credit history and opening yourself up to better credit opportunities and interest rates in the future. It doesn't work exactly like a traditional loan, and it may not be a good fit if you already struggle to keep up with your living expenses. But it's worth considering if you can spare a few dollars each month.

How credit builder loans work

When you apply for a credit builder loan, the lender will place a small amount of money -- usually between $300 and $1,000, depending on what you decide -- in a savings account. You make regular monthly payments over the course of a few months to a year, paying back the initial balance plus interest, and when the loan term is up, the bank or credit union releases the money in the savings account to you.

Because the loan amount remains in the bank until you've completely paid it off, there is no risk that the lender will lose money. If you default on the loan, it keeps what you've already paid -- and the money -- in the savings account. The lower risk means that qualification requirements are usually lower, and you may be able to get approved even if you're turned down for other types of loans.

A few lenders may offer unsecured credit builder loans, but these are rare, and you'll likely pay a higher interest rate to offset the increased risk of lending to you. Stick with a traditional secured credit builder loan if you're trying to keep your costs low.

Pros and cons

Lenders report your monthly payments to the credit bureaus, and regular, on-time payments can help boost your credit score. This increases your odds of being approved for future loans and lines of credit. Because the qualification requirements for a credit builder loan are much lower than they are for most other types of loans, you shouldn't need a co-signer, even if you have poor or no credit. 

However, these loans have just as much power to hurt your credit if you fall behind on your payments. Lenders will report these late payments to the credit bureaus as well, and this can hurt your credit score, forcing you to dig yourself out of a deeper hole.

Credit builder loans also cost you money. How much money will depend on what types of fees the lender charges, and the loan's annual percentage rate (APR). Some lenders offer single-digit APRs, while others may offer double-digit APRs. The higher the APR, the more you'll pay in interest over the loan term. While you'll get your initial borrowed amount and possibly some of the interest back, depending on the lender, you won't get every dime you paid in.

Where to get a credit builder loan

Credit builder loans are available through some banks and credit unions, but not all of them. Check with your bank or credit union to see if it offers a credit builder loan, and if not, check with other lenders online or in your area to find one that does. 

Some nonprofit organizations also offer credit bureau loans to help people build or rebuild their credit, so this is another avenue worth exploring if you can't find a local local bank or credit union that offers credit builder loans.

Factors to consider when choosing a credit builder loan

As with any loan, it's best to compare several credit builder loans before deciding which is best for you. Look at the various repayment options they offer you, and make sure you're comfortable with them. If you'd like an unsecured loan, you'll probably have to do a little more digging. The lender will give you an indication of how much your monthly payments will be. Don't agree to take on the loan unless you're confident you can pay that amount back every month. Failure to do so could harm your credit score.

You should also investigate each credit builder loan’s costs. See if there are any one-time-only fees to set up your account, and note the APR and any late fees or other charges. If the lender pays back part of the interest charges at the end of the loan term, you have to factor this into your calculation as well. Go with the loan that charges you the least overall.

Verify with the lender that it reports your payments to all three credit bureaus. Most of them should, because that's the whole point of a credit builder loan, but it's a good idea to double-check. If for some reason the lender doesn’t report your payments to all the bureaus, choose a different credit builder loan.

Alternatives to credit builder loans

Credit builder loans are one option to rebuild credit, but if you can't find a bank or credit union that offers one, or you don't want to spend money you'll never get back, there are alternative credit-building techniques that may suit you better.

First, if you have a family member or friend with a good, established credit history, you could see if he or she would be willing to make you an authorized user on his or her credit card. This enables you to make purchases on their card, and it also allows you to reap the benefits of your friend's good payment history. But you should only do this if you feel confident that you can pay back anything you spend. 

If you'd like to take out a larger loan and you're turned down because of poor or no credit, you could try applying again with a cosigner. A cosigner is essentially vouching for your responsibility, and agrees to step in and take over the payments if you're unable to. This may get you access to better loan interest rates than you would've been able to on your own.

Another option is a secured credit card. These cards are designed to help people build credit, and they work similarly to credit builder loans. You pay some money down -- usually a few hundred dollars -- and this equals your monthly credit limit. You make a few small purchases with the card and pay it back in full every month, and the card issuer reports these payments to the credit bureaus. If you decide you'd like to cancel the card once your credit has improved, the card issuer will refund your deposit, assuming you've paid all you owe. 

Credit builder loans can be a good way to build or rebuild credit, but they're not right for everyone all the time. Explore your options, familiarize yourself with the loan's terms, and compare this to some of the alternative credit-building methods described above to determine which is best for you.

 

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