Pros and cons of credit-builder loans: Will one work for you?

Your credit score is among the main factors that help you qualify for credit and set your rates. If that number is below the good credit threshhold, you might be stuck with high interest rates and expensive monthly payments.

One way to address this issue is through credit-builder loans. These loans are designed specifically for borrowers who want to raise their scores. However, they come with the same risks as any type of loan. Consider the benefits and drawbacks before applying.

Pros of credit-builder loans

A credit-builder loan is a way to show the major credit bureaus you can consistently make on-time payments. By doing so, you’ll have an easier time accessing other financial products in the future.

Can improve your credit

Most notably, credit-builder loans can improve your credit score. As you pay each month those on-time payments are reported to credit bureaus. Payment history accounts for up to 35 percent of your score, and as that track record improves, your credit score likely will too.

Flexible acceptance

Because credit-builder loans are designed for those with low credit scores and little or no credit history, lenders have much more flexible borrowing eligibility requirements. Lenders will not require good credit but instead may request information on your income, employment history and balances for your savings and checking accounts. Even with laxer eligibility requirements, lenders still want to know you can afford payments.

Ability to build savings

Typically when you take out a loan you are borrowing money to pay for a significant expense. In this case, the lender holds onto the money and sends it to you once you’ve paid it off, minus any fees. You’re essentially saving money for later. Some lenders even put your money in a certificate of deposit account where it will earn interest, though it may not be enough to offset the annual percentage rate the lender charges.

Cons of credit-builder loans

Although credit-builder loans have upsides, borrowing comes with risks.

Potential to drop credit score

As with any loan, a credit-builder loan has the potential to lower your credit score if you miss payments. Missing payments on a credit-builder loan can dramatically decrease your score and potentially put you in a more challenging financial spot.

Lenders can charge high fees

Interest rates and standard fees vary significantly among lenders. Some offer zero interest or fees and some may partially refund the interest when you pay off the loan. Others enforce steep fees that can significantly increase your expected monthly or overall cost. Common fees included prepayment penalties, origination or administrative fees and processing fees.

No immediate access to money

Credit-builder loans tend to carry repayment terms of up to 24 months, and access to the loan is not granted until after payoff. These loans are not appropriate for those who require fast access to cash, as you must fully repay the loan to get the money.

If you’re looking for fast cash in an urgent situation, explore emergency loans instead.

Are credit-builder loans worth it?

The ideal candidate for a credit-builder loan is an individual with no credit history at all. It can be hard to take out financial products without a history, and these will assist you in building that history.

Borrowers who have existing debt, on the other hand, may find less-costly, more efficient options for boosting their credit score.

A credit-builder loan is likely not the best option for borrowers with tight budgets. Rather than adding new debt, explore self-reporting your rent or getting a secured credit card for daily purchases.

The bottom line

Taking out a credit-builder loan can be a great option for some borrowers, but they are not ideal for everyone. While they are an option for those with little history, these types of loans do not provide immediate access to funds and they may come with high fees.

If your main priority is to improve your score and you feel confident in your ability to pay off the loan, a credit-builder loan can be step one to achieving excellent credit. Be sure to research the options available to you before jumping into any financial commitment.