What Is a Credit Builder Loan?
Credit builder loans can help applicants establish a positive credit history. Find out if a credit builder loan is right for you.
February 16, 2022
Having a decent credit score can be important. Your credit score can affect everything from getting loans — credit cards, car loans or mortgages — to renting the apartment you want.
A good credit score could make it much easier to get approved for credit and will also generally lead to lower interest rates on your debt.
On the other hand, if you have bad credit, or no credit history at all, it’s very difficult to get approved for loans. And the loans you do get will often have very high interest rates.
Fortunately, there are some financial products out there that can help you build a positive credit history.
Credit builder loans are a popular option, but there is a lot of confusion around how these loans work. This guide will explain everything you need to know about credit builder loans.
A credit builder loan (CBL) is a financial product that is offered by certain banks and credit unions.
Unlike most loans, credit builder loans do not require good credit. Applicants can get approved for a credit builder loan even if they have no credit history — as long as they have income to make payments.
The lender will agree to loan you a certain amount of money, which is then put in a bank account that’s controlled by the lender. You can’t directly access these funds until the loan is paid off.
You will then start making monthly payments to pay off the loan. The lender will report the loan and all the payments you make to the credit bureaus. This can help you build a positive credit history and improve your credit score.
If you can’t actually use the money, what’s the point of a credit builder loan? The main benefit is to help you build credit history. Each on-time payment you make to the lender will contribute to your credit history and could help bump up your credit score.
How do credit builder loans work?
Unlike traditional loans, you can’t really use the money that you are loaned. Instead, the funds stay “locked” in a bank account that the lender controls.
The borrower makes payments monthly until the loan is paid off. When the loan is paid off, the funds are made available.
In this way, credit builder loans are almost like a mandatory savings account. You make monthly payments, and once you pay off the original loan amount, the entire balance becomes yours to use as you please. The benefit, of course, is that you build credit history along the way.
Once paid off, you can use the funds for anything. Some may wish to use a CBL to save for a future major purchase, such as a down payment on a house.
Who should get credit builder loans?
Credit builder loans are designed to help applicants improve their credit score or build a credit history from scratch.
A credit builder loan can potentially help anyone with limited credit history. However, those who have no existing debt stand to benefit the most. A report from the Consumer Financial Protection Bureau (CFPB) found that credit scores of CBL applicants with no previous debt increased by 60 points more than the scores of applicants who did have previous debt.
Managing a credit builder loan
If you decide to apply for this type of loan, there are a few things to consider that can help you optimize the benefits.
Choose a relatively small loan
You will want to choose a loan amount that is relatively small so that your monthly payments are manageable. It’s also wise to choose a shorter term — 24 months or less — which should be plenty of time to build a positive credit history.
Make on-time payments
The credit-building benefits of this type of loan come from a record of making on-time payments. To benefit, you must actually make each required payment in full and on time. If you miss payments, this can negatively affect your credit score.
Plan out what to do with the loan amount
When the credit builder loan is paid off, you get to keep the entire loan balance — the original amount you took out as a loan.
It’s a good idea to have a clear plan for how you want to use these funds. You may want to consider using the money to start your emergency fund.
Monitor your credit score’s progress
After several on-time payments, you should start to see some positive impact on your credit score. To monitor this, you could check Credit Karma or Credit Sesame.
Use your new credit wisely
Once you have built up your credit history, you will likely be able to apply for standard loans and credit cards. Remember to use the credit responsibly to avoid excessive debt.
Other ways to build credit
If you don’t think a credit builder loan is right for you, or your bank doesn’t offer one, what else can you do to build credit? Here are a few options.
Secured credit cards
A secured credit card is similar to a credit builder loan. You apply for the card and are given a low credit limit — $500, for example. Then, you must deposit $500 into a locked bank account.
From there on out, the secured card functions as a normal credit card. If you make on-time payments, this can help build up your credit history.
Traditional loans with a cosigner
Many loan types — mortgages, auto loans, etc. — can be cosigned by another person. If that person has a better credit score than you, having them as a cosigner may help you get approved for the loan. Making regular payments toward any loan will help build your credit history.
Becoming an authorized user
If a family member or trusted friend is willing, they can add you as an “authorized user” on their credit card. This essentially means that you will be added to the account, and you can use their available credit for purchases — although you don’t necessarily need to use the account to benefit.
This should be a family member or friend whom you can trust to make on-time payments.
We’ve mentioned a variety of ways you can start building your credit history, including credit builder loans. If you’re ready to get started, find the method that works for you, and don’t forget to make your payments on time and in full.
For future loans and apartment or house leases, a higher credit score will likely bring you more options and lower interest rates.
If you need further information to help you build credit and gain control of your personal finances, sign up for the Tally newsletter today.