Credit Builder Loan: What They Are and How They Work

Credit is one of the key elements of personal finance.

Being able to secure and leverage credit is a major component to most major financial acts, and thus being able to establish yourself as a reliable user of credit will be especially important to your finances.

Despite the importance of credit, building credit if you have bad or little credit can be challenging.

There are several ways in which people can build or improve their credit, but one lesser-known method is with a credit builder loan.

As the name suggests, a credit builder loan helps you build credit and may be a good option for you.

The following will discuss the importance of credit, how credit builder loans work, where you can get a credit builder loan, and some alternatives you might consider.

What Is Credit and Why Is It Important?

Generally speaking, credit is an agreement between a lender and borrower, in which the borrower agrees to pay back money lent at a later date and with interest. Thus, any loan you have is establishing credit.

Credit can be revolving, such as with a credit card where you can borrow up to a certain amount, or an installment where a lump sum in borrowed and paid back monthly (there are a couple other types but these are the main two).

The biggest factor taken into consideration when you’re trying to establish a new line of credit is your credit score. Your credit score is a number between 300 and 850 that represents your credit worthiness. In other words, how likely are you to make your payments on time and fulfill your obligation to pay back the loan?

Your credit score is based on your credit report, which is a record of your past credit history including the types of loans you’ve had, whether you’ve made your payments on time, and whether or not you’ve had delinquencies or other issues.

The information on your credit report is tracked by three major agencies in the United States. They are TransUnion, Equifax, and Experian. These agencies take the information in your credit report and determine your credit score, which can be slightly different for each agency depending on what information has been reported to them.

The reason credit, and your credit score, is so important is because your ability to establish a good credit history will determine your ability to establish new credit and what terms you will be offered.

Those with bad or no credit will have a hard time getting loans or opening credit cards because lenders will see them as too risky. If you can get a loan, you’ll almost certainly be paying very high interest rates and be forced to accept other unfavorable terms.

While there are options for getting loans with bad or no credit, your best bet is to try and improve your credit score or to establish some credit history to begin building your credit score.

A credit builder loan is one way to do that.

What Is a Credit Builder Loan?

The purpose of a credit builder loan is solely to build credit and the funds aren’t used to purchase anything.

With a traditional loan, the lender gives you a sum of money (or a line of credit with a credit card) and you pay it back over a period of time.

A credit builder loan is just the opposite. In this case, you make monthly payments to the financial institution and receive the lump sum only once the loan is completed. You’ll still pay interest like you would with a traditional loan (to make the loan worthwhile for the lender), but you might also earn interest on the money in the account depending on the type of account it’s held in.

Lenders are willing to do credit builder loans for people with bad or no credit because they are safe for the lender. The lender receives interest for their time and holds onto the money paid until the loan is fulfilled. At no time are they lending money directly to the borrower.

How Does a Credit Builder Loan Work?

The process for establishing a credit builder loan is similar to that of a traditional loan.

You’ll first need to look at the options available and which is best for you. The important things to keep in mind when comparing institutions are:

  • Interest Rate: the interest rate, or APR, is the interest you’ll pay on the loan. The rate is a yearly interest rate that will be broken down to a monthly amount and applied to each monthly payment. The lower your interest rate, the less you’ll pay.
  • Fees: most of the time you’ll need to pay fees to establish a credit builder loan, similar to the origination fees on other types of loans.
  • Reporting: the point of a credit builder loan is to record as many on-time payments as you can in order to increase your credit score. To maximize this benefit, you’ll want to make sure the lender you choose will report to all 3 credit bureaus.
  • Loan Amount: this is the total loan amount offered. Typically, credit builder loans will be smaller total amounts, like $500 or $1,000. This is the total amount you will pay to the lender over the specified period of time, not including interest, and what you’ll receive once the loan is fulfilled.
  • Type of Savings Account: when the loan is established the lender will put the total loan amount into a savings account. Some of these accounts pay interest and others don’t. An account that pays interest is better because then you’ll be earning a little something as well as building credit.

Once you’ve decided which lender and terms you want to go with, you’ll need to apply for the loan. Applications typically include basic information about you and where you live, as well as your job and income.

It is once you’re approved that a credit builder loan differs from a traditional one.

First, the lender opens a savings account and deposits the total loan amount. You then make monthly payments for a set period of time. The length and amount of monthly payments will depend on the size of the loan, terms, and interest rate.

Every month your lender will report your payment status to the credit bureaus. If your payments are on time then your credit score should increase, but if not, your score will likely decrease, and the loan will be pointless.

Payment history is a huge part of your credit score (35% according to FICO), so establishing months of on-time payments will go a long way in builder better credit.

Once you’ve fulfilled the loan, the lender will send you the full amount of the loan along with any interest earned and you are free to do with it what you wish.

With a credit builder loan, it’s very important to make your payments on time and to make the payments as scheduled (aka, to not pay off the loan early). You want to establish as many on-time payments as possible in order to build credit and increase your credit score.

Where Can You Get a Credit Builder Loan?

You should be able to establish a credit builder loan at some of the same financial institutions that offer traditional loans, including banks and credit unions, as well as other non-traditional institutions.

While it’s possible to find banks that offer credit builder loan services, your best bet will likely be at a local credit union or with another lender that specializes in these types of loans. Unfortunately, most of the larger banks don’t offer credit builder loans.

The caveat with a credit union is that you’ll need to become a member to access their services, which means you’ll need to meet the criteria to become a member. Luckily, many credit unions simply require you to live in the area to become a member.

Another option is to look at online lenders or institutions that specialize in these kinds of loans. For example, Self Financial, Inc., or just Self, specializes in credit builder loans.

Just make sure you do your due diligence to ensure the company you’re interested in is credible. You can read independent reviews and check out their Better Business Bureau rating to help you establish credibility.

Alternatives to a Credit Builder Loan

A credit builder loan is a great option for those looking to build or improve their credit, but it’s not the only option.

Credit Cards

Another way to build credit is to open and use a credit card.

The pros to using a credit card to build credit is that you’ll be buying things you want/need rather than tying your money up in an account that you can’t access until the loan is fulfilled.

However, credit cards carry risk. It’s easy to get into the habit of carrying a balance and paying the minimum payment each month, which can get you into serious trouble. Credit card interest rates are typically high, and it can be hard to pay your balances if you get into the habit of paying interest.

We only recommend using a credit card if you can be disciplined enough to only pay for what you need and can afford, and then pay your balances off every month. If you can pay your credit card the right way, it can be a great tool for building credit.

Personal Loans

Another credit building option is to take out a personal loan. A personal loan is a traditional loan in which the funds borrowed can be used for any purpose. They are typically unsecured, meaning you don’t need to put up collateral to get one.

Personal loans typically have lower interest rates than credit cards, but you may have a hard time getting one with decent terms if you have bad or no credit. In these cases, you may need to look for a secured personal loan that does require collateral, which means you may lose that asset if you default on the loan.

However, if you need funds for something other than a car or home, a personal loan will generally be a better option than using credit cards.

Become an Authorized User

The last credit building alternative we’ll discuss is becoming an authorized user on a credit card.

An authorized user has the ability to use the credit card account for purchases but is not the account holder and is not the person the account terms are based on.

Even though the account is not based on the authorized user, the user benefits from any positive credit history built with the account, including on-time payments and credit utilization.

The risk with becoming an authorized user is that the user must be extremely disciplined in their spending and diligent in paying their share of the payments. Ultimately, responsibility for the account falls on the account holder, so if the user runs up a bunch of debt or fails to make payments then the account holder will be stuck with the bill.

If someone is willing to help you out by adding you as an authorized user, you better repay their trust and use it as an opportunity to better your credit.

Moral of the Story

It can be hard to qualify for new credit when you have bad or no credit history, but there are options.

Before you’re in a position where you have to settle for a loan with a high interest rate and bad terms, look to improve your credit score.

A credit builder loan is one way to build credit and improve your credit score. You’ll make payments with interest to the lender, and when the loan is fulfilled, you’ll receive the lump sum plus any interest earned while the money was sitting in the savings account.

The lender will report your payments to the credit bureaus, and as long as you make your payments on time, you should see your credit score increase over the life of the loan.