Credit Builder Loan, Personal Loan, and Payday Loan – What’s the Difference?

credit builder loan vs. payday loan

By Michelle L. Black

There are many similar terms in the world of personal finance. Take credit cards and debit cards, for example. While these two forms of payment sound and even look alike, the way they work is quite different.

The same is true of loans. You’ve probably heard of credit builder loans, personal loans, and payday loans before. Yet, although the word “loan” is attached to each title, there’s a big difference among these three financial products.

In this guide, you’ll learn about credit builder loans, personal loans, and payday loans. Once you understand how each product works, you’ll be able to judge whether it deserves a place in your financial life.

What Is a Credit Builder Loan?

A credit builder loan is a type of installment loan that you can use to help build your credit. Yet unlike traditional loans where you can access the money you borrow right away, with a credit builder loan you have to wait.

You can find credit builder loan offers from certain banks, credit unions, and Self. When a lender approves your application, it typically holds your funds in a savings account or certificate of deposit (CD). The money will sit in the account until you’ve made your final monthly payment to satisfy the debt.

Here’s an example. Suppose you qualify for a $1,000 credit builder loan with a 12-month repayment term. You’ll need to wait at least one year before you can withdraw your funds, assuming you make all your payments on time. (Actual loan amounts, interest rates, fees, and repayment terms can vary.)

Credit builder loans typically represent less risk to lenders than other types of financial products. After all, you won’t receive the money you borrow until you pay your loan balance in full. As a result, you may qualify for a credit builder loan even if your credit history is damaged or if you have no credit history whatsoever.

What Is a Payday Loan?

A payday loan is a small-dollar, short-term loan that some people use to cover emergency expenses. It’s common for these loans to be limited to $500 or less. Often, you must repay the amount you borrow by your next pay period.

Payday loans are a notoriously expensive form of financing. The Consumer Financial Protection Bureau (CFPB) warns that the typical APR for payday loans hovers around 400%. In some states, the APR on payday loans can climb to 1,000% or more.

The reason people may use payday lenders, despite their horrible fees, is because they’re an easy way to borrow money. Even with credit problems, there’s a good chance you’ll qualify as long as you have a checking account and proof of income.

But payday loans are best avoided. They border on predatory and sometimes cross that line outright. If you ever have to roll over a payday loan you can’t afford to pay off, you risk creating a dangerous debt cycle that’s hard to escape.

What Is a Personal Loan?

A personal loan is another type of installment loan. You borrow money from a lender, generally at a fixed rate, and repay those funds in fixed monthly payments (installments) until the end of the loan term. These loans typically require a credit check.

The interest rate on a personal loan can vary based on the condition of your credit and other factors. As of the time of this writing, the average interest rate on a 24-month personal loan is a little over 10%, per the Federal Reserve. Yet rates on personal loans may range between around 6% and 36%.

Some personal loans are secured, meaning that you pledge an asset (like your house or car) to back the loan. If you can’t repay the loan as agreed, the bank can seize your collateral to try to recuperate some of its losses.

Other personal loans are unsecured. With unsecured loans, you don’t have to supply an asset as collateral to qualify for financing. However, because you’re not giving the bank a way to reduce its risk, the interest rate you pay may be higher.

Key Differences

1 - Which loans can help you build credit?

Both credit builder loans and personal loans may have the potential to help you build and improve your credit rating. Payday loans do not. Yet whether a credit builder loan or a personal loan helps or hurts your credit comes down to a few important factors.

First, the loan must report to the credit bureaus (Equifax, TransUnion, and Experian) to potentially help you improve your credit reports and scores. That’s why a payday loan will never build your credit. Payday loans only appear on your credit reports if you fall behind on your payments and the debt is turned over to a collection agency.

For a loan that does appear on your credit reports, a well-managed account is crucial. Pay the account on time throughout the life of the loan and your credit should benefit. Make late payments or, worse, go into default and your credit could be damaged instead.

2 - What’s the best option if you need to borrow money fast?

A credit builder loan can be a great option if you want to establish credit. But it’s not a solution that will help you borrow money for immediate emergency expenses. If you need fast access to cash, personal loans or payday loans are your better options.

As mentioned, payday loans should be avoided. So, let’s look closer at personal loans. You can find personal loan offers from banks, credit unions, and online lenders. Having better credit can make it easier to qualify for a personal loan (and a decent interest rate). But lenders may consider other factors, like your income and existing debts, too.

In general, you should aim to have a credit score of 600 or higher to qualify for a personal loan. Some lenders might issue you a loan below that credit score threshold, but you should expect higher rates and fees in exchange. Still, even a bad credit personal loan is probably much more affordable than a payday loan.

If you hope to qualify for better-than-average interest rates, a FICO Score of 740 or higher might help. Of course, every lender sets its own credit score criteria, so that number isn’t set in stone. Nonetheless, Experian defines a FICO Score of 740-799 as “very good.”

Can’t qualify for a personal loan at all? A payday alternative loan (PAL) from a local credit union may be another option to consider.

Can You Fix Bad Credit to Get a Better Loan in the Future?

Your credit has an influence over many areas of your financial life — including your ability to borrow money at an affordable rate. When your credit improves, you may qualify for lower interest rates and better terms from lenders. A better deal on financing can help you keep more of your hard-earned money in your bank account, where it belongs.

There are many ways to try to improve your credit. You can review your credit reports for errors and try to fix mistakes if you find any. Establishing new credit, like secured credit cards and credit builder accounts, might also be a step in the right direction.

Above all, it’s essential to develop the habit of managing the accounts you do open carefully. You should make every payment on time and try to avoid high debt-to-credit limit ratios on your credit cards.

As you follow these rules, your credit may begin to improve over time. Eventually, all of your small, positive changes could add up to something amazing.

About the author

Michelle L. Black is a leading credit expert with over 17 years of experience in the credit industry. She’s an expert on credit reporting, credit scoring, identity theft, budgeting and debt eradication.

Written on December 5, 2019

Self is a venture-backed startup that helps people build credit and savings.
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Disclaimer: Self is not providing financial advice. The content presented does not reflect the view of the Issuing Banks and is presented for general education and informational purposes only. Please consult with a qualified professional for financial advice.

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