What Is a Credit-Builder Loan?

Highlights:

• Credit-builder loans are designed for borrowers with low or no credit scores; however, they work a bit differently than other types of loans.
• Credit-builder loans allow you to take on a small amount of debt and demonstrate that you’re a reliable borrower.
• Making regular on-time payments toward a credit-builder loan may help you establish a history of positive credit behavior.

Building a credit history from scratch can be tricky. How do you access credit when you don’t have a credit score for lenders to review in the first place? For some individuals in need of credit, the answer may be in something called a credit-builder loan.

How does a credit-builder loan work?

Credit-builder loans are designed for borrowers with low or no credit scores; however, they work a bit differently than other types of loans.

When you’re approved for a traditional loan, you receive the money up front and repay the lender, with interest, over a certain period of time. With a credit-builder loan, however, the lender deposits your money into a certificate of deposit or savings account. This money is then held as collateral, and you will not receive it until the loan is repaid.

You’ll be responsible for making a series of fixed monthly payments, plus interest, to the lender for the duration of your loan term. Depending on the details of your loan agreement the lender may release some of the borrowed funds when you make a monthly payment, or they may hold the full amount until you’ve made your final payment. You will generally receive the original loan amount, minus any fees. Some lenders will also reimburse you for a portion of the interest you paid.

Credit-builder loans are typically offered in small amounts — usually between $300 and $1,000 dollars — by smaller lenders, such as credit unions, community banks and online lenders.

How credit-builder loans may impact your credit history

Credit scores are a reflection of your credit history that lenders use to predict your ability to pay off debts. People with no or low credit scores are categorized as risky borrowers. Credit-builder loans allow lenders to offset that risk by holding money in an account as collateral, while still offering consumers an opportunity to build a strong financial profile.

But how do these loans work to improve your credit scores? Just like with traditional loans, lenders report your payment activity to the three nationwide consumer reporting agencies—Equifax^®, TransUnion^® and Experian^®.

In most credit scoring formulas, payment history accounts for the most significant portion of your credit scores. So, generally speaking, the foundation of a favorable credit history is a good payment history. Credit-builder loans allow you to take on a small amount of debt, make regular payments on time and demonstrate that you’re a reliable borrower.

However, this also means that missing even one payment jeopardizes your hard work. Late payments appear on your credit report after 30 days and remain there for seven years. So, if you can avoid the pitfalls of irresponsible financial behavior, these loans can be a great strategy for building your credit history and paving the way for you to access credit to pay for important expenses in the future.

Credit-builder loans: pros and cons

Find out if a credit-builder loan might be the right choice for you by weighing the pros and cons.

Pros:

• Credit-builder loans are easier to qualify for than a traditional loan, especially for people with poor or no credit histories.
• If you make regular on-time monthly payments, credit-builder loans are a good opportunity to improve your credit scores.
• Higher credit scores mean you’ll have a better chance of being approved to take on important future debt, such as mortgages and auto loans.
• You can use the money from the loan to help boost your savings.

Cons:

• Missed payments can decrease your credit scores and quickly set you back financially.
• You can only access the loan after you repay it, so it’s not a good choice for anyone who needs money immediately.
• Credit-builder loans are only available in small amounts.
• Fees and interest rates can add up, especially if you already have a tight budget.
• Interest rates and other details vary widely between lenders, so it’s important to know the terms of the loan you apply for.

Who should pursue a credit-builder loan?

You won’t need good credit scores to be approved for a credit-builder loan, which means they’re perfect for those with poor or no credit history. There are all kinds of people who fall into this category, often called “credit invisible,” including young people who are just starting their financial journey, low-income workers who can’t afford to take on debt and people who simply haven’t used credit for years.

A study by the Consumer Financial Protection Bureau found that borrowers with no existing debt tend to have the greatest success with credit-builder loans. So if you’re considering this type of loan, especially if you have other sources of debt, make sure you’ll be able to keep up with any credit card bills, student loan payments and other financial obligations while paying back your credit-builder loan.