What Is a Credit-Builder Loan?
Janet Schaaf is a freelance writer, editor and proofreader who considers reader advocacy to be her calling. After taking a few roads less traveled, Janet completed a bachelor’s degree in English Literature from the University of Missouri-Kansas City, with English Department Honors. She has been correcting grammar and checking facts since she could string a sentence together. For the past three years, Janet has focused on making personal finance topics understandable and relatable. Loan terms and credit card agreements can look overwhelming, but understanding what you’re agreeing to is paramount in grasping the impact debt can have on your life.
Building credit is a Catch-22: You must have credit to get credit, but how do you start with zero? That’s where a credit-builder loan could help.
With a credit-builder loan, a lender holds your loan as a deposit. Then, it will release the funds after you pay your loan in monthly installments. If you make on-time payments, you could finish your loan term with a new, positive credit score.
How do credit-builder loans work?
Traditional personal loans come with a wide range of loan amounts and repayment terms. Once approved, a lender will release your funds as a lump sum (minus an origination fee, if your loan has one). About 30 days after your loan is disbursed, you begin to pay it back in monthly installments, including interest.
Credit-building loans work the opposite. Here, a lender places your loan in a locked savings account, and your funds are only available after you make monthly payments. Some lenders will release a little bit of your loan with each payment you make. Others give it to you as a lump sum after you’ve paid your loan in full.
Credit-building loans come with fewer options than typical loans. Loan amounts usually range from $300 to $1,000, and repayment terms generally span from six to 24 months.
It can be hard to meet personal loan requirements if you have bad (or no) credit. However, credit-building loans pose little risk for lenders. If you don’t pay back your loan, it will not disburse your funds. As a result, you’re more likely to be approved for a credit-building loan even if traditional lenders have turned you down.
Since credit-builder loan lenders report your payments to the major credit bureaus, credit-builder loans help you establish a payment history (which makes up 35% of your credit score). If you make your payments on time, you may generate (or improve) your credit score.
Are credit-builder loans worth it?
Whether a credit-builder loan is worth it depends on your financial situation, your goals and your ability to hold up your end of the deal. It’s important to know that these loans usually come with interest and that they can do more harm than good if you don’t use them correctly.
The Consumer Financial Protection Bureau (CFPB) also wondered whether credit-builder loans actually work, so it conducted a study in 2020. Here’s what it found:
- Borrowers were 24% more likely to have a credit score after taking out a credit-building loan, but only if they did not have any existing loans already. Those with past loans probably already had a credit score.
- After paying off a credit-builder loan, debt-free borrowers’ credit scores went up 60 points more than those with existing debt.
- Credit-builder loans caused a slight drop in credit scores for borrowers already in debt.
Based on these findings, a credit-builder loan could be a better option if you are trying to build credit from scratch. If you already have debt and want to improve your credit score, you might want to explore alternatives.
Credit-builder loans pros and cons
Credit-building loans aren’t the best choice for everyone. Review the pros and cons before jumping into a contract.
| Pros | Cons |
|---|---|
May generate a credit score. Credit-builder loans might help you bulk up your credit profile if you have no borrowing history. Accessibility. It’s easier to qualify for a credit-building loan than a traditional loan. Lower APRs. Credit-builder loans usually carry lower APRs and interest rates than credit-builder credit cards. | Can be risky. If you miss a payment, your credit score will likely drop. Not free. You will likely have to pay interest or other fees on your credit-builder loan. Requires more debt. Credit-builder loans are just another form of debt that you’ll need to pay back. Ties up funds. Unlike other loans, you have to make payments before your funds are available. |
How to manage a credit-builder loan
1. Evaluate your budget. Before you take on any form of debt, it’s essential that you can afford to pay back what you borrow. Don’t just consider the total amount of your loan but also your APR and any other fees. Ask the lender how much your monthly repayments will be and see if you can work them into your budget.
2. Compare offers. Since every credit-building loan offers different features, check out more than one lender to find the best deal. It could be a good idea to select the loan with the lowest APR and fees, as this will lower the overall cost of your loan. That is, as long as you’re comparing loans with identical loan amounts and term lengths.
Additionally, some lenders will conduct a hard credit pull to check your eligibility. This may cause a small drop in your credit score. Since every point counts when you’re building credit, you might want to prioritize lenders that allow you to prequalify (as that only requires a soft credit pull).
3. Make your payments on time. Taking out a credit-builder loan doesn’t inherently build or improve your credit. For that, you must also make on-time payments. Even if you have the best intentions, a late or missed payment can leave you worse off than when you started.
4. Check your credit score. It can be gratifying to see your credit score improve by using a credit monitoring service as you pay off your loan. Also, keeping tabs on your financial health may empower you to stay the course after you pay off your credit-builder loan.
To get started, consider LendingTree Spring. This free, powerful tool provides credit scores, credit alerts, money-saving tips and more.
5. Bulk up your emergency fund (if possible). Many people take out credit-builder loans with the sole intent to build or improve their credit rather than to borrow money. If that applies to you, you may want to consider adding the money to an emergency fund.
While it’s not usually a good idea to take on debt just to sock the money away, if you have no other use for your funds, an emergency fund could help you avoid falling behind (and damaging your credit) in the face of the unexpected. Consider a high-yield savings account to earn ample interest.
Where to find a credit-builder loan
Credit-builder loans are somewhat niche, so they can be hard to find. You may have luck by researching credit unions, online lenders and lending circles.
Credit unions
Some credit unions offer credit-building loans, but you must be a member to qualify. You might need to pay a small fee to join, and the credit union could have specific eligibility requirements. However, credit unions tend to offer low APRs, so it may be worth jumping through some hoops.
One credit union you may want to check out is DCU, or Digital Federal Credit Union. It offers large credit-builder loans with a $3,000 maximum loan amount and at 5.00% APR (as of November 2023).
Online lenders
Online loan lenders are a popular spot to get credit-builder loans, but taking the online route has benefits and drawbacks.
Take the online lender Self, for instance. Self specializes in credit-builder loans, but its APRs are higher than those of many credit unions. On the plus side, you can cancel your loan at any time and get your money back (minus interest and fees).
Lending circles
A lending circle can be a simple way to borrow money, interest free. Under this model, you and other members of your circle chip in money every month which then gets placed into a combined pot. Then, one member receives the pot each month, round-robin style.
Mission Asset Fund (MAF) is a non-profit organization that helps bring six to 12 people together to form a lending circle. And unlike informal lending circles between family and friends, MAF reports payments to the three credit bureaus.
Alternatives to credit-builder loans
Loans aren’t the only way to build or improve your credit. Consider below:
Secured credit card
Like a credit-building loan, a secured credit card requires an upfront deposit. Then, the issuer will give you a credit card with a limit equal to your deposit.
Unlike a credit-building loan, you’ll be able to use your card right away, and you’ll have to pay back what you borrowed each month. Once you’ve proven yourself to be a responsible borrower, the issuer might offer you a traditional credit card (and refund your deposit).
Become an authorized user
A trusted friend or family member could add you as an authorized user to their credit card, and you won’t need to submit to a credit check. As an authorized user, you can charge purchases to the card as you please but you won’t be responsible for the debt you accrue. As long as you and the account holder use the card appropriately, you might build or improve your credit.
Keep in mind, though, that if the account holder falls behind on their payments, both of your credit scores will suffer.
Pay down your current debt
The amounts you owe to creditors for revolving debt (such as credit cards) makes up 30% of your credit score. This debt also impacts your credit utilization ratio, or the amount of available credit you’re using at the moment.
If you already have a lot of revolving debt, you may want to consider paying down what you currently owe. By doing so, you could improve your credit score and save a significant amount in interest.
Frequently asked questions
Yes. Although credit-builder loans are easier to qualify for, the lender will deny you if you don’t meet its minimum requirements.
It’s not ideal to pay off a credit-builder loan early. The point of this type of loan is to establish a positive payment history. The longer your credit-builder loan is open (and the more on-time loan payments you make), the more you’re demonstrating to future lenders that you are a responsible borrower and the more you’re extending your credit history.
How much you borrow depends on your ability to pay it back. It may seem like a bigger loan would boost your credit score faster than a smaller loan, but if you can’t make your loan payments on time (every time), you’ll likely take a hit to your credit score.