Credit Builder Loans: The Definitive Guide

what's a credit builder loan?

By Zina Kumok, Financial Health Counselor, Credit Counselor

If you're new to credit, or trying to rebuild your credit but struggling to gain access to the right tools, a credit builder loan might be just the ticket.

Read this guide to learn:

So if you're establishing credit or have bad credit and you're looking for ways to improve your credit, this guide is for you.

Let's get started!

What is a credit builder loan?

A credit builder loan is an installment loan that exists for the sole purpose of helping build positive credit history.

The main difference between credit builder loans and a more traditional loan (like a personal loan) is that you don't get the money until you've finished making every loan payment.

By holding onto the loan funds as you make regular payments, the lender is able to reduce its potential loss should you prove unable to make your payments.

Here’s how it works:

  1. You apply for and open a credit builder loan at a bank, credit union or through Self. A credit union may also call this type of loan a share secured loan (being secured by your savings account).
  2. When your application is granted, the financial institution moves the loan proceeds you were approved for into a separate account, usually a savings account or certificate of deposit (CD). The loan amount tends to be between $300 and $1,000, though some banks offer credit builder loans as high as $2,500.
  3. You then begin making your monthly payments for the predetermined amount of time (the loan term). The loan term can be as short as six months or as long as six years.
  4. The bank, credit union or service provider reports your monthly payment activity to one or more of the three major credit bureaus (Experian, Equifax, Transunion). A credit bureau generates a credit rating (also known as a credit score, based on your history of using credit).
  5. Once the loan balance reaches zero, the service provider unlocks the CD or savings account and returns the total money the borrower paid, minus any interest and administrative fees.

Who should get a credit builder loan

The people most likely to benefit from a credit builder loan are those with a low credit score, which FICO calls very poor or fair (learn more from FICO here). Your FICO score is important because most lenders in the U.S. use the score as part of their lending decision process. A poor FICO score is 580 or below and a fair FICO score ranges from 580-669.

People with a starting credit score below 600 are more likely to see a positive impact from a credit builder loan over time, according to analysis of Self Financial customer data. The Self Financial study did not include people who are new to credit, or who may not yet have a credit score yet because they have no credit history, but if you have no credit history, a credit builder loan can help you establish credit history.

If you already have an installment loan that reports to a credit bureau and is showing on your credit report, you might not need a credit builder loan.

Other types of installment loans typically include:

  • Student loans
  • Auto loans
  • Mortgages
  • Other unsecured loan (personal loan)

Learn how to read your credit report here.

If you don't already have an installment loan, but you have a credit card, you may still benefit from a credit builder loan. That's because the credit scoring models place some value on your ability to manage different types of credit. A credit card is known as a revolving credit line, meaning it is open ended, whereas an installment loan has a fixed term and amount.

How credit builder loans affect credit score

While you’re making loan payments, the lender should report your payment activity to each major credit bureau:

  • Experian
  • Equifax
  • TransUnion

Read this article learn more about what a credit bureau is.

Your payment history counts for 35% of your FICO score, which is the largest share, according to FICO.

Making timely payments in full each month helps build positive payment history, which should put you well on the path a good credit score over time.

Opening a credit builder loan can help you build this payment history, since part of the process involves making regular payments.

Like any financial product, a credit builder loan is a tool, so how you use it matters. If you make payments on time, the lender will report positive payment history to the credit bureaus. Making your payments on time and in full is key to a good credit history.

If, on the other hand, your payments are late or not for the full amount, your lender reports that to the credit bureaus, too, which could lower your credit score.

Because most credit builder loans have a term of 12 months or more, you’ll have a solid history of on-time payments once your credit builder loan is completed.

That improved credit history can make it easier to access other future loans (like an auto loan) or credit cards, and a better interest rate on those credit products.

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Where to get a credit builder loan

Because a credit builder loan is designed for those with no credit, you don’t need good credit to be eligible. You can even apply if you don’t have any credit history at all.

You typically just have to:

  • Be at least 18 years old
  • Be a US citizen or permanent resident
  • Have a Social Security number
  • Have a bank account, debit card or prepaid card (so you can make payments)
  • Live in one of the 50 US states

You can find a credit builder loan through certain community banks, local credit unions, some online banking sites, or at Self Financial, which is available online or via mobile app in all 50 states.

Just remember to compare terms and shop around when looking for a loan.

Why pick a credit builder loan?

Credit builder loans often have a low annual percentage rate compared to credit card APRs that are often over 20% when you have poor credit (see a selection at Wallethhub) or payday loans that can have APRs in excess of 100%. The loan amounts are often small compared to a student loan or mortgage, and the loan terms are relatively brief compared to a 10-year student loan or 15- or 30-year conventional mortgage. See more about student loan debt at Student Loan Hero.

You still have to be responsible when using a credit builder loan.

If you miss a payment, the lender will have to report that to the credit bureaus, just as it would your on-time payments. If you don’t have a long credit history, one late payment can make a big impact.

To avoid paying late, set up automatic payments to use funds from your bank account to pay your credit builder loan. Check to make sure the monthly payment went through, and use calendar reminders as an extra precaution.

Autopay can help get you on the right track towards being a responsible borrower and establish good habits to use for your next secured loan.

Other ways to build your credit

A credit builder loan is just one tool that could improve your credit. A secured credit card is another popular way to build credit.

Unlike traditional credit cards, a secured card requires a deposit to act as collateral. Usually the deposit is between $200 and $2,000. The deposit will equal the card’s credit limit, and you have to submit the deposit before you get the card. (The Self Visa® secured card works a little differently.)

You can use a secured credit card online and at retailers just like any other major credit card.

Just make sure the card issuer reports to all three credit bureaus if you want your management of that credit line to help you build credit.

After a few months of using the card responsibly, the provider may upgrade you to an unsecured credit card (often thought of as a traditional credit card), so you can get your security deposit back.

Whether it's secured or unsecured, just remember to use your credit card wisely.

Since secured credit cards often have lower credit limits, it’s easy to use a lot of your available credit line. Many credit experts advise people to keep credit utilization below 30% to maintain or improve their credit score.

Your credit utilization percentage makes up 30% of your FICO score, making it the second largest factor, according to FICO.

To illustrate credit utilization, if you have a credit card with a $200 credit limit, then having a balance of more than $60 brings your utilization over 30%.

You can spend that amount easily with one trip to the grocery store. Be sure to monitor your usage carefully.

The other major consideration with any credit card is interest. If you don’t pay your balance in full by the due date, you’ll be charged interest.

Secured credit cards often have a higher interest rate than traditional credit cards because they are being offered to people with poor credit, so this mistake can be costly.

About the author

Zina Kumok is a Financial Health Counselor and Credit Counselor who writes extensively about personal finance.

Written on April 3, 2019

Self is a venture-backed startup that helps people build credit and savings.
Comments? Questions? Send us a note at hello@self.inc.

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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