What a credit-builder loan is and how it works

Getting a credit-builder loan is similar to getting any other type of loan. You must show that you earn enough income to make the payments, verify your bank account and address and provide a government-issued ID. Unlike a regular loan, however, you don’t get any funds in your pocket until you’ve made all the agreed-upon payments.

A credit-builder loan can be a great tool to improve your credit score after a rough financial patch or start to build one if you don’t have a score. You get to choose the loan amount and length of the repayment term, and lenders report your monthly payments to the credit bureaus — just like with a traditional loan. If it’s the right choice for your finances, you can follow a few simple steps to take one out.

What is a credit-builder loan?

A credit builder loan is a special type designed to give individuals with no credit history or a poor credit score a chance to prove they’re creditworthy before receiving any loan funds. To receive the borrowed money, you must make all the scheduled payments first. The lender holds the total loan amount in a secured account until the loan is paid off.

Every payment you make on a credit-builder loan is reported to credit agencies, and over time the payments can help boost a bad score or help you build a credit score if you don’t have one. Once you’ve made all the payments, you’ve built a satisfactory history with the lender and can access the full amount you borrowed.

How credit-builder loans work

Credit-builder loans work in reverse of traditional loans. You make payments before you receive your funds, versus receiving funds and making payments like you would with other loan types.

The lender sets aside the amount you’re approved for in a secure savings account, and you pay monthly towards this sum. Depending on the lender, interest and how your funds are paid out will vary.

• You pay interest with each monthly installment, and the payment minus interest is released into your personal savings account.
• Once you have fully repaid the loan, the funds are fully released minus any interest and fees.

Each payment you make is reported to at least one of the main three credit bureaus, which may boost your current score or give you the credit history to produce a score if you don’t already have one.

Who is a credit-builder loan for?

People new to credit, like recent high school or college graduates, may benefit from a credit-builder loan to help develop a credit score. Borrowers who haven’t used debt may also see a bump in their scores after making credit-builder loan payments.

A 2020 Consumer Financial Protection Bureau (CFPB) study found that people without any debt received the biggest credit score benefit from a credit-builder loan. Participants in the study saw 60-point improvements in their scores versus borrowers who had existing debt.

Nearly one in four consumers in the study who had no score increased the likelihood of having one using a credit-builder loan. However, this type of loan may hurt borrowers with current debt — the study showed a score drop among those participants.

Once you have a credit score, you can apply for other credit products to help you along your financial journey, whether it be a credit card, personal loan or even a mortgage. But a credit score is important for more than just financing purchases — you may be required to have a good credit score to land an apartment, get a good insurance rate and, in some cases, it can make getting onto a utility account easier.

When to avoid a credit-builder loan

If you are in a crisis and need emergency funding, a credit-builder loan will not help. Because the funds are disbursed slowly and are only what you pay into them, they won’t be able to help in a pinch.

Instead, you should research emergency loan options and alternatives. While an emergency loan can be an easy solution if you qualify, they can also be expensive — nonprofits and negotiation may save you some cash and help you through.

How to get a credit-builder loan in 6 steps

Getting a credit-builder loan is relatively easy — there are typically no credit checks involved, and you could get your account set up the same day you apply. That said, there are still a few steps to follow for you to get the most out of your loan.

1. Review your monthly budget

Don’t take on a new monthly payment unless you’ve checked your monthly spending. Remember, you don’t receive any funds upfront with a credit-builder loan. Start with a small loan amount so you can afford the payment and avoid a situation where you can’t repay the balance.

2. Check your credit history

Although credit-builder loan eligibility criteria aren’t as focused on your credit scores, checking your credit history for any issues affecting your approval is a good idea. You can get a free copy of your credit report from Experian, TransUnion and Equifax by visiting AnnualCreditReport.com. Disputes may take up to 30 days to be addressed, so be sure to give yourself ample time between reviewing your report and applying.

If you want to check your current credit score, check with your bank, credit union or credit card company — they typically offer free credit monitoring to their customers. It’s worth checking for free options before signing up for a paid service.

3. Compare your options

It’s always best to shop around before you choose a credit-builder loan. You may get a better rate, more flexible repayment terms or lower costs by checking with multiple lenders. Pay attention to the following when comparing lenders that offer credit-builder loans:

• Loan amounts. Although the amounts may vary from lender to lender, most credit-builder loans are between $300 and $3,000. The more you borrow, the higher your payment will be, so starting with a smaller loan is best.
• Repayment terms. In lending, your term is the length of time it takes to repay the loan. Credit-builder loan terms tend to be shorter, from 12 months to 36 months. The shorter your term, the higher your monthly payment, but the lower interest you’ll pay overall. Some lenders offer terms up to 48 months.
• Flexibility. In general, you won’t have access to credit-builder loan funds until you’ve made all the payments. However, some lenders may allow you to receive some of the balance after you’ve made a set number of payments. Others may release money into your account after each monthly payment.
• APRs and fees. Your monthly payment may not cover interest and fee charges. In such cases, those costs are deducted after you’ve made all of your scheduled payments, which can take a big chunk out of the funds you receive.

4. Gather all the necessary information

Credit-builder lenders usually require the same documents needed for a personal loan. The requirements may vary among lenders but usually include:

• A picture ID like a driver’s license or passport.
• Your Social Security number and date of birth.
• Your phone number, address and email address.
• Copies of paystubs, W-2s or tax returns to prove your income.
• Employer contact information.
• Your bank account number and routing number.
• Proof of your monthly rent or mortgage payment.

5. Apply

Once you’ve chosen the credit-builder lender you want to do business with and have your documents ready, you’ll fill out the lender’s full application. The process is typically all done online, and you can upload your financial paperwork through a portal on the lender’s website.

At this point, the lender will do a hard credit pull and make a decision — and you’ll possibly receive an answer within seconds. If you are approved, review the terms carefully and ask questions if you don’t understand how much you’ll pay each month, what the fees are and when you’ll get access to the loan funds.

6. Make payments and track your progress

Once you sign your final documents, you’ll begin making your monthly payments. Most credit-builder lenders set up automatic payments through your bank so you don’t miss a payment. If the lender offers a mobile app or online tracking option, use that to stay on top of your payment progress.

After you make payments for a few months, start tracking your credit score progress. Ask your lender if it offers a free credit monitoring service and enroll in it so you can keep watch for movement in your scores.

Other options for building credit

A credit-builder loan isn’t the only way to improve or build your credit score. There are many other options worth considering to find the option that best suits your needs and timeline.

• Secured credit card: If you’re looking for ways to build credit, a secured credit card can be a valuable option. These types of credit cards require that you establish a savings account with the credit card issuer and maintain a certain balance. These funds act as security for the line of credit.
• Become an authorized user: If a parent, family member or spouse has a solid credit profile and a credit card account in good standing, ask if you can be added as an authorized user to the account. That individual’s credit history will then be added to your credit profile.
• Make bill payments on time: If you simply have a low credit score that you’re looking to improve, ensuring that you establish a consistent track record of paying all bills on time can help increase your score over time.
• Pay down existing debt: Yet another way to improve a low score is by focusing on paying down any existing debt you may have. Minimizing balances on credit cards and personal loans can go a long way toward improving a credit score. Credit experts generally recommend borrowing less than 30 percent of your available credit limits.

Bottom line

A credit-builder loan can be a helpful tool to build or improve your credit score. However, because you don’t receive all the funds until you’ve made all the payments, it’s important to pick an amount that won’t squeeze your budget. A credit-builder loan can be a stepping stone towards a stronger financial future if used responsibly.