What Are Credit-Builder Loans And Do You Need One?

Starting with no credit can be frustrating. Every lender wants you to have credit so they can give you more, but where do you start? A credit-builder loan can ease your frustration and be a practical way to build credit.

What Is A Credit-Builder Loan?

As you probably guessed by the name, credit-builder loans help you build credit. They are great for people with no credit but also beneficial for those with bad credit.

It's not a traditional loan where you receive the proceeds after approval, but the ultimate goal in this type of loan is to build credit, not borrow money.

How Do Credit-Builder Loans Work?

Credit-builder loans are similar to traditional loans in that they have an APR (annual percentage rate/interest rate) or cost to borrow the funds and a 6 – 24-month loan term. Unlike traditional loans, though, the funds from credit-builder loans are held by the lender until you repay the full amount borrowed.

The lender holds the funds in a secure account, which protects them should borrowers stop making payments.

After repaying the loan, you receive the funds in one lump sum, which you could use to start an emergency fund, pay off a large debt, or pay for a large expense, such as college or a down payment on a house.

Most lenders report clients' payment histories to the credit bureaus. Look for a lender that reports payments to all three credit bureaus, not just one. This increases your chances of improving your credit scores and getting approved for future financing if you make on-time payments.

However, if you miss payments or make them more than 30 days late, it could hurt your scores, so be sure you only commit to a payment you can afford.

Keep in mind that your credit score won’t change immediately after taking out a credit-builder loan. How fast your credit score changes depends on how often the lender reports the account to the credit bureaus.

Typically, they report 1 day after your due date, but every lender has different rules.

Who Could Benefit From A Credit-Builder Loan?

Several groups may benefit from a credit-builder loan, including the following:

• People who are credit-invisible: The National Credit Union Administration defines credit-invisible people as those with a limited or no credit history. A credit-builder loan with a lender that reports payments to the credit bureaus can help you start building your credit score.
• People struggling to qualify for a mortgage: The average credit score of American consumers to qualify for a mortgage is 620. If you're close but need a boost, a credit-builder loan may increase your score by a few points.
• People with bad credit: If you’ve had credit mishaps in the past, it can take a while to overcome them and improve your credit score. Credit-building loans can help you achieve those goals faster without the requirement to spend money.
• People who want to save money: If saving money is challenging, a credit-builder loan may provide the best of both worlds. You may improve your credit score with on-time payments and have money saved for you while you make your payments.
• People who want to improve their credit: Even if you don't have “bad credit” but would benefit from a higher score, a credit-builder loan may help. A higher credit score may give you lower interest rates or better terms on future loans.

The Benefits And Drawbacks Of Credit-Building Loans

Opting for a credit-builder loan is a big decision. It affects your credit and increases your monthly liabilities. Here are the pros and cons to consider.

How To Find, Secure And Manage A Credit-Builder Loan

Credit-building loans are a specialty product that may not be available at traditional banks and lenders. Your best bet is to look at smaller community banks and credit unions.

• Check your budget: The point of a credit-builder loan is to improve your credit score. Since your payment history is the largest part of your score, you should know how much you can repay each month before borrowing a loan.
• Gather the necessary paperwork: Like a traditional loan, you must prove you can afford the loan by providing your paystubs, W-2s and tax returns. You’ll also provide information about your bank accounts and current debts. Lenders use this information to ensure you can afford the loan.
• Compare lenders: Try to get quotes from two or three lenders. This gives you the chance to compare your options and choose the loan with the most attractive terms.
• Submit an application: After choosing the right loan, complete the loan application and provide any necessary paperwork.
• Make on-time payments: Making payments on or before your due date could improve your credit score.
• Plan wisely for your loan payout: Before repaying the loan in full, plan how to handle the funds you receive. For example, will you start an emergency fund, pay off a debt, or put it toward a large purchase you've planned?

Alternatives To Credit-Builder Loans

If a credit-builder loan isn’t the right fit for you, several alternatives exist that may be just as beneficial.

Secured Credit Cards

Secured credit cards require a security deposit that you provide. The deposit becomes your credit line, and you can use it like a regular credit card to make purchases. The deposit is the bank's “insurance” if you don't make your payments.

Many credit card companies consider upgrading you to an unsecured credit card after 6 – 12 months, but it varies by bank. Like traditional credit cards, your payments are reported to the credit bureau, and on-time payments could help improve your score.

Becoming An Authorized User

If you have close friends or family with good credit habits, consider asking them if you can be an authorized user of their credit card. If they have a credit card with a bank that reports payments and credit behavior for authorized users to the credit bureaus, it may help improve your credit score.

However, if the credit cardholder misses payments or exceeds their credit limit, it could also hurt your credit score.

Personal Loan

A personal loan comes from a bank or lender and can be secured. They provide you with funds upon approval. Most lenders require good credit scores to qualify for a personal loan, and you can use the funds for many purposes, such as buying a car or making home improvements.

FAQs About Credit-Builder Loans

Credit-builder loans have many benefits, especially if you are credit-invisible. Here are some more questions people have about them.

How much can I get with a credit-builder loan?

Most lenders and credit unions have low credit-builder loan limits of up to $1,000; however, some may allow loans as high as $3,000.

Can I pay off my credit-builder loan early?

You can pay off a credit-builder loan early, but it doesn’t work to your advantage to do so. Since the point of these loans is to build credit, which requires on-time monthly payments, you might cut yourself short if you repay it too early.

Are credit-builder loans worth it?

It’s a personal decision to decide if credit-builder loans are worth it.

If you know you can make the payments on time and will make good use of the funds, such as setting up an emergency fund, they are worth it. But, if you cannot make the payments on time or will not use the proceeds wisely, other options may be better.

Do credit-builder loans give me money upfront?

No, lenders hold onto your funds until you make your final payment. They are not like traditional loans, which pay the funds upfront.

Do credit-builder loans work?

If you make your payments on time, credit-builder loans work. They are best for those without any credit history because they help you build a positive one. They may not be as effective for people with bad credit.

The Bottom Line

Credit-builder loans may help you build credit in an entirely different way from traditional loans. They offer the best of both worlds, forcing you to save while also helping to improve your credit score.

If you are unsure of your credit score or whether a credit-builder loan would fit into your budget, download the Rocket Money℠ app today.