If you don’t have a credit history or you have a low credit score, a credit builder loan, as the name states, can help you to build your credit. You can get a credit builder loan without good credit, but you need to have enough income to make the loan payments. Credit builder loans are different than traditional personal loans, so it’s important to understand how they work before you apply.
How Do Credit Builder Loans Work?
Think of a credit builder loan as a traditional loan in reverse. When you take out the loan, you don’t get the loan proceeds until you’ve made all the payments plus interest. Essentially, it’s like putting money into a savings account, but the cash is not available to you until you’ve paid the loan in full.
A credit builder loan costs you money in the form of interest, but making on-time payments on the loan for the full term can raise your credit score. It also provides you with a lump sum of cash at the end of the loan term.
Consider this example:
- Loan amount: $1,000
- Term: 12 months
- Interest rate: 12% APR
- Monthly payment: about $88.85
- Total paid over 12 months: about $1,066.20
Here’s what happens:
- The lender holds the $1,000 loan amount.
- You make payments of about $88.85 for 12 months.
- Payments are reported to the credit bureaus.
- Once all the payments are made, you get $1,000.
The loan has cost you approximately $66.20, but if you’ve made all the payments on time, you’ve got 12 months of positive credit history, which may have raised your credit score.
Note that some lenders may also charge fees for the loan, which will add to your total cost.
Qualifying for a Credit Builder Loan
Your credit score is usually not a factor in qualifying for a credit builder loan, but lenders will generally want to verify your employment and income to make sure that you can afford the payments. They may also look at your debt-to-income ratio (DTI), which is the amount you pay on debts compared to your income. For example, if you earn $6,000/month and have $1,800 in monthly debt payments, your DTI is 30%. The lower your DTI, the better.
If you are applying for a loan at a credit union or local bank, they may also require that you have a checking or savings account.
Why Get a Credit Builder Loan?
Credit builder loans generally are a good idea for people in two categories: those with no credit history, and those with bad credit.
If you have no credit history at all, a credit builder loan establishes your credit profile and score. This can help you to potentially be approved for a credit card or another type of loan, which can help build your score even more. If you make all payments on time, this can open the door to getting a car or home loan in the future.
If you have bad credit, a credit builder loan won’t negate your poor payment history, but making on-time payments for the entire term of the credit builder loan can boost your score. Then you can continue building your credit in other ways.
Pros and Cons of Credit Builder Loans
Credit builder loans have both pros and cons that you should consider.
Pros of Credit Builder Loans
- Can help you build a positive payment history and increase your credit score.
- Easier to qualify for than conventional loans.
- Encourage savings and give you a lump sum of money at the end of the loan term.
- Can help you diversify your credit mix, which can help to boost your credit score.
Cons of Credit Builder Loans
- You don’t get the loan proceeds until the loan is paid in full.
- You’ll pay interest, and sometimes fees.
- Missing payments can hurt your credit.
- Not all lenders report to all three major credit bureaus.
- The positive impact on your credit score is not guaranteed.
Who Provides Credit Builder Loans?
Not all lenders provide credit builder loans. The types of institutions that may offer them include:
- Credit unions: The most common providers of credit builder loans are credit unions, although you may need to become a member.
- Community banks: Smaller community banks are more likely to offer credit builder loans than larger banks.
- Community Development Financial Institutions (CDFIs): CDFIs specialize in providing financial products for people with limited or bad credit.
- Online lenders: Many online lenders offer credit builder loans.
What to Look for When Shopping Credit Builder Loans
Different credit builder loans come with different terms and features. When shopping for a credit builder loan, you should look for:
- A loan amount that gives you a payment that you know with certainty that you can afford.
- Lower interest rates and fees.
- A lender that reports to all three major credit bureaus.
- A lender that reports payments monthly. This may help to build your credit faster.
- No early payoff penalties.
What Should You Do with the Loan Proceeds?
Once you have successfully made all your payments and receive the loan proceeds, it may be tempting to splurge on a purchase, but it may be a better option to try to improve your financial situation even more. Consider paying down other debts or putting the money into a savings account where you can earn interest. Paying down debts can improve your credit score even more, and putting money into a savings account gives you emergency funds that you can use if an unexpected expense arises.
Alternatives to Credit Builder Loans
Credit builder loans are not the only option to build your credit score. You can explore several alternatives.
- Secured credit cards: If you have some cash in the bank, you may be able to get a secured credit card, meaning that your saved money is used as security for the credit line. For example, if you have $300 in a savings account, you can get a credit card with a $300 limit. The savings account money is frozen until the credit line is closed, or when you qualify for an unsecured credit card, but you can use your credit line and pay it off each month to build your credit score.
- Become an authorized user: You could ask a friend or family member to become an authorized user on one of their credit cards. On-time payments on that credit card may be reported on your credit report, thus helping your score.
- Rent reporting: In some cases, you can have your on-time rent payments reported to one or more of the credit bureaus.
- Secured loan: Also known as a share-secured loan, a secured loan is a loan secured by money that you have in the bank. It’s similar to a secured credit card, but you get a lump sum of loan proceeds and make regular payments on it just like a personal loan. The money you have in the bank is frozen until the loan is paid off.
- Starter credit card: If you have no credit history, some lenders do offer small credit line credit cards that can help you to build your credit history.
In Closing
Credit builder loans can help to build your credit if you have no credit history or a negative credit history. They can be the first step in improving your financial situation. Just be sure that you can afford to make all the payments and make them on time to have the best chance of boosting your credit score.
