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Credit Builder Loans: Boosting Your Credit With Debt

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If you’re trying to repair or build your credit, a credit builder loan could be a good option. While these loans aren’t widely advertised, they’re specifically designed to help consumers show they can make consistent, on-time payments before actually receiving a loan’s proceeds. You won’t get a guarantee with a credit builder loan, but the loan might help your credit if you make your payments on time.

What is a credit builder loan?

A credit builder loan is set up specifically to help you build credit. It’s similar to a traditional personal loan, as it requires you to pay interest in installment payments over a set period of time. However, with a credit builder loan, you don’t actually receive your funds right away. Instead, the lender sets the funds aside into an escrow account or a restricted savings account, like for a certificate of deposit (CD). The money acts as a security deposit for your loan, and your lender typically gives you access to your credit builder account only after your loan has been fully repaid.

With a credit builder loan, there’s no guarantee your credit score will rise a great amount, but loan payments are generally reported to all three major credit bureaus and on-time payments may help improve it. These loans are widely available at credit unions, community banks and online lenders. Some lenders offer credit builder loans with no credit check, which means your score won’t be dinged due to a hard credit inquiry.

Key things to know about credit builder loans:

  • The loan amount is held in a separate account. The amount you borrow is typically locked in a savings account or CD that secures your loan.
  • You can choose a short repayment period. It’s likely you’ll have 12 to 24 months to repay your loan, but some lenders offer shorter repayment terms, like six months. That means you might be able to access your funds sooner.
  • They’re often small loans. You don’t need to borrow a lot of money to build credit. Many credit builder loans are for $1,000 to $3,000.
  • The lender reports your account to the credit bureaus. Credit building programs can help build credit because your lender will likely report loan payments to the three major consumer credit bureaus, Equifax, Experian and TransUnion.
  • They’re not free. Most lenders will charge interest on your loan and may also charge a fee to open your account.
  • You usually receive the funds after repaying the loan. Once you’ve fully paid off your loan, you’ll receive the money that was set aside in a separate account. In some cases, a lender may let you access some of the funds or interest earnings as soon as the account is opened, or as you make payments.

You should expect to pay interest on a credit builder loan. However, the loans are generally less expensive than installment loans for bad credit borrowers.

With some credit building programs, you’ll be able to earn interest on the money you set aside. If the lender is a credit union, the account may be called a shared savings account, and you’ll likely see the earnings referred to as dividends rather than interest. If you default on paying back a credit builder loan, your lender may return only what you’ve already paid in, instead of the balance plus earnings. Your credit score could also take a hit.

Credit builder loans: Pros and cons
Pros Cons
  • Easy to qualify for, often without a credit check
  • May allow you to build credit while also growing savings
  • Lenders may charge interest and fees
  • Defaulting on payments could hurt your credit score

Loan interest rates and fees

  • Upfront fees. Many credit builder loan companies charge an upfront, nonrefundable fee, which may be called an application fee, administrative fee or processing fee.
  • Annual percentage rate (APR). Interest rates and fees for credit builder loans vary widely, with APRs ranging from 0% to 15% or more.
  • Annual percentage yield (APY). The APY on a credit builder account determines how much interest you’ll earn. While it’s likely you won’t earn a lot of money on a small loan, a higher APY will lead to lower loan costs overall.
  • Prepayment penalties. You probably won’t be charged a prepayment penalty for paying off your loan early, and any fees you do see will likely be nominal. However, if your funds are in a CD, you may have to pay a penalty for closing the CD.

How to find and apply for a credit builder loan

Decide whether you can take on new debt

Before looking for a credit builder loan, assess whether you’ll be able to keep up with payments. Borrowers who took out credit building loans were more likely to be late paying back other loans, especially if they already had existing debt, according to a recent Consumer Financial Protection Bureau study.

If you’re struggling to pay your bills, look for a credit builder loan that comes with both a low loan amount and a low monthly payment. Your payment history can be the most important factor that determines your credit scores, constituting about 35% of your FICO Scores. Even a single late payment, defined as being more than 30 days past due, might hurt your credit scores.

Compare credit builder loan companies

Look for a credit builder loan online and from branch-based financial institutions like credit unions. Besides offering credit builder loans, several online lenders also offer credit builder cards, which are credit cards secured by money you first deposit into an account before it becomes active.

Because they’re not-for-profit institutions, credit unions often offer lower interest rates and fees than traditional banks. However, you’ll likely need to be a member before opening an account. In some cases, a credit union may also require you to take a financial education course to qualify for their credit builder loan program.

Review terms and apply

  • How the loan is secured. Most loans require collateral, which will be the loan proceeds that are kept in a separate account. In addition, some lenders offer an unsecured credit builder loan, but it may come with a higher interest rate.
  • The APR and APY. To find a loan that will cost you the least overall, look for one with the lowest APR and the highest APY. Lenders may refund part of your interest payments — perhaps half — if you’re never late with payments. Some loans come with both a 0% APR and a 0% APY.
  • The initial fee. The charge for opening an account is often nominal (say, $25, as an example). If fees are a concern, look for a lender that either doesn’t charge an upfront fee, or is willing to refund it if you take a personal finance class.
  • Credit reporting policy: Make sure your lender will report both your account and loan payments to the three main credit bureaus.
  • Policies for late and missed payments. You may get a grace period, or you may be charged a penalty if you’re as little as one day late. Once your payment is late 30 days or more, your lender is allowed to report it to credit bureaus, which may cause your score to drop. With some loans, a lender may automatically make a payment using a borrower’s account, or close it before 30 days are up, to avoid reporting the payment as late.
  • Apply either online or in person. The application process varies by lender, but most likely you’ll first be asked to provide basic information, like your name, address and government I.D. You may also be able to choose the loan amount and repayment terms. Some banks may require you to visit a branch to verify your identity and sign a disclosure agreement.

How to manage your new loan

  1. Make your payments on time. Set up automatic payments to lessen the chances you’ll forget, and make sure you have enough in your bank account to avoid overdrafts.
  2. Keep your account open. Unless you have a specific reason for paying off the loan early, considering keeping it open for its entire term. This will help grow the number of on-time payments reported to your credit reports.
  3. Communicate with your lender. If you’re having trouble affording your monthly payment, don’t wait to reach out to your lender until after the due date. Your lender may be willing to work with you to help bypass a hit to your credit score.

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