A credit builder loan allows people with a bad credit report — or no credit history at all — to build positive credit history. Unlike some traditional loans, which are often unsecured, a credit builder loan works like an installment loan except you don’t get your money until you finish making all the loan payments. With this type of loan, holding onto the money until you complete all the payments helps to reduce the risk to the bank. If you are looking to build good credit, this post gives you the details on how a credit builder loan works, how to find them, and other options to help build a positive credit history.
A credit builder loan typically has four main phases, broken down below:
The cost of a credit builder loan can vary depending on the lender. Compare loan offers by considering the differences between these three main factors that affect the total cost of your loan:
To help you understand how a credit builder loan works and the costs associated with one, we walk you through a hypothetical example that illustrates the process of applying for one:
Important: Keep in mind the interest rate is different from the APR, because APR calculates the total cost of borrowing money including interest rate and fees, whereas the interest rate is just the percentage of the loan you’re charged for.
A credit builder loan may be a good option for you if you need to build credit but can’t qualify for a traditional loan. Credit builder loans can help you build healthy money habits as long as you make payments on time, which can affect your payment history. However, missing a payment could make your credit even worse, so be careful.
These loans can have a positive impact on those who take them out and faithfully make payments. The Consumer Financial Protection Bureau (CFPB) conducted research, for which enrollment took place from September 2014 to February 2015, and released its findings in 2020. The CFPB research found that a credit builder loan increased the likelihood of establishing a credit score for participants without an existing loan by 24%. Those same participants saw their credit scores increase by 60 points more than participants with existing debt. Also, the credit builder loan resulted in an average increase in participant’s savings balance of $253.
However, for those who participated in the study and had existing debt, the credit builder loan seemed to have a negative impact on their credit scores. Those with existing loans had their scores impacted by a slight decrease, indicating that they may have experienced difficulty making credit builder loan payments on top of their current obligations.
Credit builder loans can hurt your credit score if you miss payments or let the loan go into default. To help prevent damaging your credit, set a realistic monthly budget to ensure that you can make on-time payments and give yourself a better chance at building a positive credit history.
If you’re looking for a credit builder loan, there are a few places where you can find one. Four in particular will be your best bets.
If you’re not convinced that a credit builder loan makes sense for you, consider some of these alternatives from financial institutions.
A secured credit card gives you access to a line of credit upfront in exchange for a security deposit usually in the form of a savings account or certificate of deposit that’s used as collateral. This deposit sets your credit limit. You still have to make monthly payments on purchases you make — the deposit doesn’t cover your monthly payment — so make sure you use this option responsibly to improve your credit, or you risk causing more damage to your credit history.
Another alternative to a credit builder loan, you can become an authorized user if you know someone who would be willing to add you to their credit card account. Becoming an authorized user can help improve or restore credit, as long as you and any other user continue to make on-time payments, the credit utilization ratio (CUR; the total balance of the card divided by the total credit limit) remains low and the account has been open for a while. Of course, you risk damaging your own and the other person’s credit if the converse is true: Your friend or family member makes late payments or none at all, the CUR is high or the account has been just recently opened.
A personal loan can also allow you to develop a positive payment history and have a mix of credit options on your report. Your credit mix accounts for 10% of your FICO® score, so if you add a new type of credit product to your history, you may see an impact on your score if you make on-time payments. If you handle a variety of credit products well, you show lenders that you may be a lower risk to lend to. Of course, because payment history accounts for 35% of your score, making on-time payments, or the lack thereof, can have the most impact on your score.
Although personal loans may sound like the perfect alternative, keep in mind that personal loans can have their downsides as well. Personal loans tend to charge a high APR (annual percentage rate), which represents the total cost of the loan, which includes the interest rate and applicable fees. Interest rates for personal loans may be fixed or variable interest rates, and those with lower credit scores may be charged a higher interest rate.
A fixed rate doesn’t change over the loan term, but a variable rate can change based on whatever index your lender uses to calculate rates. So what may look like an affordable rate can fluctuate over your loan term. So carefully consider the loan terms and how a variable rate could impact your monthly budget before taking on a loan with a variable rate that could go up and make your payments higher.
If you think a credit builder loan may work for you, just remember the basic differences from traditional installment loans where you get a lump sum upfront and make monthly payments to pay the loan off. With credit builder loans, you make monthly payments to the lender who puts the money into a certificate of deposit (CD) or a savings account. Once you’re done making all the payments, the lender returns that money to you (minus interest and fees). With payments reported to the credit bureaus, not only do build savings, but making on-time payments may also help to elevate your credit score.
Ana Gonzalez-Ribeiro, MBA, AFC® is an Accredited Financial Counselor® and a Bilingual Personal Finance Writer and Educator dedicated to helping populations that need financial literacy and counseling. Her informative articles have been published in various news outlets and websites including Huffington Post, Fidelity, Fox Business News, MSN and Yahoo Finance. She also founded the personal financial and motivational site www.AcetheJourney.com and translated into Spanish the book, Financial Advice for Blue Collar America by Kathryn B. Hauer, CFP. Ana teaches Spanish or English personal finance courses on behalf of the W!SE (Working In Support of Education) program has taught workshops for nonprofits in NYC.
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