What is a credit-builder loan and how does it work?
Creditors design credit-builder loans to help you build credit from scratch or improve your credit health. It’s ideal for individuals who have bad credit or no credit at all and have trouble getting approved for credit cards or traditional loan products.
You’ll most likely get a loan from $200 to $2,000, payable in six to 24 months. The monthly payments are also usually affordable, but there’s another key advantage for credit newbies and credit-challenged consumers — the ability to potentially build credit while saving money.
How a credit-builder loan works
If you’re approved for a credit-builder loan, the bank will deposit the entire loan amount into an interest-earning savings account. You’ll make a fixed monthly payment for a set period and receive the loan proceeds (minus applicable fees) at the end of the loan term.
Most lenders charge an administrative fee to open an account. Monthly payments are usually automatically deducted from your bank account to streamline the repayment process and prevent you from missing payments. The impact on your credit score generally depends on your credit history.
How to use a credit-builder loan to your advantage
Credit builder loans help you build credit by reporting monthly payments to the three credit bureaus — Experian, TransUnion and Equifax. Payment history accounts for 35 percent of your FICO score, so timely payments boost the amount of positive activity reported in your credit profile. In turn, your credit score could improve over time.
Plus, you’ll build up savings while making payments towards your credit-builder loan balance. Once the bank releases the funds, you can stow them away in a savings account, make a big-ticket purchase or use them however you see fit.
Where to get a credit-builder loan
Credit-builder loans are available through an assortment of lenders, including:
Credit unions: If you aren’t yet a member of a credit union, you’ll typically need to apply for membership before you can apply for a credit-builder loan.
Community banks: You likely won’t find these loan products through large brick-and-mortar banks, but many local, regional and community banks offer credit-builder loans.
Lending circles: These entities offer credit-building plans, which entail interest-free loans that report to the credit bureaus for use by groups of relatives or friends. Each member deposits the agreed-upon amount into a central fund each month. Every month, a member of the fund receives cash, and everyone continues to pay in until all the members have received money from the central fund. Refer to the database on the nonprofit Mission Asset Fund’s website to find lending circles in your community.
Online lenders: Several online lenders, like Self, feature low-cost credit-builder loans that you can apply for and receive a decision in minutes. If you’re leaning towards a credit-builder loan, confirm the lender is licensed to do business in your state before applying.
How to apply for a loan
Most lenders don’t require a credit check to qualify for a credit-builder loan. However, they may review your banking history through ChexSystems, Early Warning Systems or another consumer reporting agency to determine your eligibility for a loan – adverse entries, like bounced checks and excessive overdraft fees, could hurt your chances of getting approved.
When you’re ready to apply, you’ll usually be asked to provide the following information and documentation:
Your name, date of birth and Social Security number
Your current address and phone number
Your routing and bank account number
A copy of your driver’s license, U.S. passport or state-issued photo identification
Your monthly mortgage or rental payment
Other ways to build credit
A credit-builder loan is just one way to begin your journey toward better credit. There are other alternatives to consider, including:
Secured credit cards: You’ll get access to a credit card with a limit that’s based on the required security deposit you make upfront. You can use a secured credit card like any other credit card, and you’ll need to pay at least the minimum payment each month to keep the account in good standing. Your card also reports your payment activity to the credit bureaus each month. Ideally, you want to keep the balance at or below 30 percent of the credit limit to help boost your score.
Personal loans: Some lenders offer unsecured loans to those with poor or limited credit histories. However, these loans may not be worthwhile as they’ll likely come with a steep interest rate since they pose an elevated risk to the lender. If you can get a secured loan backed by collateral, you could qualify for more favorable terms.
Self-reporting: Ask your landlord and service providers to report payment activity to the credit bureaus. They’re not obligated to do so, but could grant your request for free or in exchange for a nominal monthly fee.
You can also ask a relative or friend with exceptional credit history to add you to their credit card account as an authorized user. If they agree, you’ll have the authority to make purchases on the account without being on the hook for payments. Even better, you won’t have to undergo a credit check, and all the positive payment history from the account will also reflect on your credit report. You can request to be removed from the account as an authorized user at any time.
Bottom line
Whether you want to build credit from scratch or improve your credit score, a credit-builder loan can lend a helping hand. This affordable solution is designed to help you improve your credit health. Plus, you could save money, making a credit-builder loan a win-win.
Before applying, shop around to find a lender with a loan product that works for you. Also, explore other credit-builder alternatives as they may be a better fit for your financial situation.
