Articles, Borrow, Finance

What is a Credit Builder Loan? And is it Right For You?

Written By: Rick Orford
Reviewed by: Mike Reyes
Last Updated November 18, 2022

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millennial couple learning to Start Flipping Houses With No Money

Are you wondering, “what is a credit builder loan?” In this article, I go over everything about it and how you can get started getting one.

Figuring out how you can build your credit is a mystery for many consumers. Indeed, it’s a question many ask when they don’t know how credit works. Luckily, there are different ways to build credit despite having a low credit score or even no credit score. One of the excellent ways to improve a credit score is by getting a loan. 

The Mechanics of Credit Builder Loans

I had no credit when I was 18, like millions of consumers. I could not get a credit card without a credit score, and I didn’t know anything about secured credit cards. A friend suggested I improve my credit score by getting a loan from one of those places with neon lights, as they report the payment history to the credit bureau. And once the loan gets paid, I will have a credit score high enough to get a credit card.

So that’s what I did. I went to the store with the neon lights and promptly got a loan for $1,000. It was a signature loan, and I had to repay $101.97 a month for 12 months. Easy, I thought! But I failed to understand that this loan came with a 39% APR! Instead, I saw it as paying $223.64 in interest. At the time, I didn’t need a loan. But, to me, it was the cost of obtaining a credit rating.  

Credit builder loans fill the gap without risk or the predatory 39% interest rate. If you haven’t heard of such a loan, you are not the only one.  

Let’s dig in.

Credit score

Consumers who want to get a credit card, car loan, or mortgage will almost always start with checking the borrowers’ credit scores. 

The credit score influences whether the lender will approve your loan and the interest rate you are needed to pay. Indeed, it’s challenging to get credit cards or loans with no credit or a thin credit report. But, with a credit builder loan, it’s possible! It’s an ideal solution to establish good credit by reporting on-time payments. 

Understanding a credit builder loan 

If you need a personal loan and either call or visit your lender (bank, credit card company, finance company, etc.), you’ll start by filling in a credit application. You might even sign some forms, but this doesn’t happen every time for unsecured lending. If you’re lucky, you’ll have instant access to cash, thanks to your lender. Then, you’ll pay it back sometime in the future.

On the other hand, a credit builder loan builds your credit first, and then you borrow later. It’s like a loan but in reverse.

Where do I start

With a credit builder loan, you start by setting a credit limit that works for you. But, unlike a traditional loan, the lender doesn’t give you cash immediately. Instead, you set up a payment plan and start making monthly payments. Then, the lender deposits the payments in an interest-bearing savings account, or CD. Each time you make a payment, the lender reports it to the credit bureaus. And doing so improves your credit score. 

The loan carries no repayable interest, but there may be a small fee for the account setup. Then, at the end of the term, once you’ve paid the loan, the lender will send you back all the money, perhaps even with interest!  

In the credit industry, these loans are known as secured loans. With secured loans, the borrower offers collateral upfront to the lender, credit union, or bank. The money gets held in a savings account. Then, at the end of the term, the money returns to the borrower, sometimes with interest.

A secured loan is an excellent way for consumers can use it to build their credit. But remember, the difference between a traditional loan, and a credit builder loan, is that, with the latter, the payments become the security. 

How do they influence your credit score? 

A credit builder loan is an inexpensive strategy to improve your credit score as an installment loan. It features fixed monthly payments – similar to an auto loan, mortgage, and personal loan. The payments you make then get reported to credit bureaus. And that is what helps you to establish your credit score. 

When calculating a credit score, payment history is the most significant factor. Naturally, you should make timely payments, as agreed on your loan. By doing so, you will be able to improve your credit score over time. 

The ideal term

The first step to building your credit score is applying for a loan with a payment term of at least six months. Six months is ideal for your credit score to increase, as you’ll have six months of consistent payments. For this reason, it’s essential to make the payments, on time, for six months.

A credit builder loan also helps establish a sound financial discipline that includes saving for your goals. And it can also help you to open other financial products, including personal loans, credit cards, or even a mortgage.

For this reason, these loans are an excellent option to build your credit. However, I can’t stress it enough. It’s essential to make your payments on time and ensure they get reported correctly.

Another important consideration is that credit builder loans often cost a little less when comparing it with a traditional credit card or secured loan, so long as you make your payments on time. 

Before considering a credit builder loan to build your credit score, think about:

  • What are your chances of qualifying for a traditional loan 
  • Your borrowing needs 
  • Choosing a reasonable amount to borrow (How much can you comfortably repay, monthly)
  • Look for a suitable loan from a lender 
  • Checking your credit regularly and monitor your progress

Will it improve your credit score? 

credit score range

First and foremost, for any loan to help improve your credit, there are two things that must happen: pay the loan on time, and ensure payments get reported to the credit bureau.

Payment history accounts for 35% of your FICO credit score. And nearly all banks, credit unions, and other lenders rely on the FICO score to make a credit decision. With on-time payments, they help you establish and build your credit rating. On the other hand, late or missed payments are a problem as they will harm your credit score. 

Before you can choose this option to build your credit score, you must check with your lender to ensure your payments will get reported to the three credit bureaus: TransUnion, Experian, and Equifax. It’s important to know because each credit bureau calculates your credit score differently.

Each credit bureau calculates your credit score based on information in your credit file. Therefore, with a credit builder loan, if your payments only get reported to one of the three credit bureaus, you may have a higher credit score at one and a lower score at the other two. 

How Much Does A Credit Builder Loan Cost? 

The primary reason to apply for a credit builder loan is to help borrowers build their credit scores. While these services are low-cost, these services are not free. The lender may charge you service and late fees, particularly if you’re late making payments.

Borrowers should also verify if there is a prepayment penalty. A prepayment penalty is a fee the lender charges you if you pay the loan in full before the end of its natural term. 

Do I need a credit builder loan? 

a millennial reading a book about investing

Now that you’re aware of a credit builder loan’s ins and outs, ask: is it a good idea to get a credit builder loan? 

A credit builder loan is excellent when you have poor credit or no credit score. And if you go with this option, it’s essential to make your payments on time; that’s because the credit builder loan helps you improve your credit score. With excellent credit scores, you are more likely to get future loans, such as a car loan, credit card, or mortgage.

On the other hand, traditional loans are good options as well. They will help access money right away. However, a traditional loan will be harder to approve if you have no credit score or poor credit.

The downside to credit builder loans

Unfortunately, these credit builder loans have a downside. If you have a low credit score or no credit, you’ll pay application fees, interest, and administrative fees. These types of amount charges will not be refunded even after you make all your payments on time.  

The reason for paying the fees and interest is to get a better credit score in exchange, much like I did when I was 18. But in an unfortunate event where you can’t make your payments, your credit score might get damaged. 

For this reason, it’s essential to feel comfortable with your monthly payment. A credit builder loan might be right for you as long the payment fits well within your budget.

Do I have other options?

Of course, if you already have savings, you might consider an alternative, such as a secured credit card. With a secured credit card, you only have to deposit once, and then you may access your credit line. Indeed a secured credit card becomes an effective way to build your credit. However, paying your balance with a credit card in full at month’s end, before the due date, is essential. By doing so, you won’t pay interest.

Where do I get a credit builder loan? 

It may be tougher to find a credit builder loan than you expect. This type of loan is new and isn’t like a traditional loan. If you decide on getting one, consider contacting your local banks or credit unions and other competitors before you make a final option. Some online lenders can also offer you credit builder loans. Take time and research your options to get the best offers and one suitable depending on your specific financial situation. 

For example, you can get a 12-month term loan with a credit limit between $500 to $100. The interest rate will vary and depends on your loan provider. 

What to consider when getting a loan 

  • The APR – refers to the annual percentage rate. It is the amount your lender will charge you after you borrow the funds. If you can get the interest rate is below 10%, that would be best. However, some lenders charge higher rates. 
  • Other costs – A lender may charge you application fees or late fees after failing to pay on time. 
  • Credit limit – When borrowing, remember a larger amount takes you longer to pay back, and thus paying more interest. 
  • Loan repayment term – The longer you take to pay back your loan, the more interest you have to pay. 

Therefore, it’s best to work with a lender who can offer you favorable terms to improve your credit score without spending a fortune. 

How can someone apply for a credit builder loan? 

The process of applying for this credit-building option is similar to other types of loans. The lender may ask for your details: address, name, social security number, phone number, and even date of birth. Other information required may include income, employment history, savings, and debt obligations.

However, before you apply, consider your credit. It will give you insight into what the lender will see after checking your credit during the loan application process. Therefore, you will quickly narrow down the loans you can qualify for and know the interest rate to pay after being awarded a credit builder loan.

Final thoughts

A credit builder loan is an essential service that helps you establish your credit. But this is not an optimal choice in most cases. The fees you incur and the inability to get the money until you’ve paid your existing loan off may disappoint you. 

Before choosing a credit builder loan, look for other alternatives, like being an authorized user from a friend’s or relative’s credit card account. Another option is to have a secured credit card. You can offer a security deposit as collateral and in exchange, a credit limit about the same amount as the amount you deposited. And, with a credit builder loan, you only get access to your funds after paying the loan and interest. 

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