- A credit builder loan is an installment loan you can use to build credit.
- The funds of a credit builder loan are usually locked in a savings account until you pay off the entire amount in full.
- Interest you pay on a credit builder loan could come back to you in the form of dividends.
- As the lender reports your on-time payments to the credit bureaus, you could see your credit score improve.
If you have poor or nonexistent credit, it can be difficult to borrow a loan, open a credit card or even rent an apartment. Fortunately, there are ways to build credit or establish it from scratch.
One approach is to take out a credit builder loan, which is a type of installment loan. As you make on-time payments on a credit builder loan—and those payments are reported to major credit bureaus—you could see your credit score improve.
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What is a credit builder loan?
“A credit builder loan is a way to build your credit score,” says Joel Ohman, a Certified Financial Planner and president of insurance marketplace Clearsurance. “If you have no credit history or poor credit, this loan can be an excellent way to turn your financial situation around.”
Unlike a traditional loan, you don’t receive the funds from a credit builder loan upfront. Instead, the lender locks the loan in a savings account or certificate of deposit (CD) until you’ve paid off the amount in full.
Once you’ve completed repayment, the account is unlocked and the funds become available for you to use as you wish. Paying off a credit builder loan is similar to setting up automated savings, but it has the added benefit of building your credit as you go.
Your lender will report your payments to one, two or all three of the major credit bureaus, Equifax, Experian and TransUnion. Your payment history makes up a major part of your FICO credit score (35%).
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Making on-time payments on your credit builder loan can improve your score, while late payments can damage it. If you’re aiming to build credit, it’s crucial to stay current on your monthly bills.
How does a credit builder loan work?
Since a credit builder loan is designed to help you build credit, you don’t need good credit to borrow one. Rather than looking at your credit score, a lender will typically review your income and employment situation to make sure you can pay the loan back on time.
Most credit builder loan amounts fall between $300 and $1,000, according to the Consumer Financial Protection Bureau (CFPB). You’ll likely have to pay interest charges on the principal amount you borrow.
You might get some of these interest charges back, though, in the form of dividends. Some lenders pay these dividends on a monthly basis throughout the duration of your loan term, whereas others pay them out at the end of your loan term.
Most credit builder loan terms span 6 to 24 months. According to FICO, you need an account that’s at least six months old to establish a credit score in the first place. As long as your credit builder loan spans a minimum of six months—and your lender is actively reporting your payments to one or more credit bureaus—it can help you establish credit.
Example of a credit builder loan
Before borrowing a credit builder loan, check in with your budget to make sure you can afford the monthly payments. Let’s say, for example, you borrow a six-month credit builder loan of $600 at a 6% interest rate.
In this scenario, expect to make six monthly payments of about $102 and pay a total of around $11 in interest, according to a Calculator.net’s loan calculator. (As mentioned, you might earn some dividends on your savings along the way, depending on your loan agreement.)
Once you’ve paid off your loan in full, you’ll have $600 to use however you like. If you don’t need the funds right away, it might be a good idea to stash that money as an emergency fund that you can draw on for future unexpected expenses.
Pros and cons of credit builder loans
Depending on your situation, there may be both advantages and disadvantages to credit builder loans. Consider both before you apply.
- Can establish and improve your credit: One of the biggest benefits of a credit builder loan is its potential to build your credit. As you make on-time payments, you should see your credit history lengthen and your credit score go up.
- Helps you build savings: Since you access your credit builder loan funds after you’ve paid them off, you’ll have a savings fund at the end of your loan term.
- Could pay out dividends: Many lenders share the dividends that your savings earn while sitting in your savings account or CD. While the amount probably won’t be much, it can help subsidize your interest charges.
- Charges interest: Credit builder loans typically come with interest charges, which may or may not be worth it depending on your situation and credit goals. Some lenders also charge administrative fees, so keep an eye out for any extra charges that could add to your costs of borrowing.
- Late payments could damage your score: While a credit builder loan is meant to help you build credit, making late payments could damage your score.
Also, it should be said that credit builder loans aren’t the only way to improve your credit. There are other strategies, such as…
Credit builder loans vs. personal loans: What’s the difference?
Credit builder loans and personal loans are both installment loans that you pay off with fixed monthly payments over a certain number of months or years. When you borrow a personal loan, however, you receive the loan funds as a lump sum upfront.
You can typically borrow anywhere from $1,000 to $100,000, depending on your credit, the loan amount and borrowing purpose. Repayment terms usually range from two to seven years. Most lenders require fair or good credit to qualify for a personal loan, as well as proof of sufficient income.
You can use a personal loan for just about any purpose, from debt consolidation to home renovation to vacation expenses. As of September 2022, advertised interest rates typically fell between 4% and 36%, with strong-credit borrowers getting the lowest rates.
If you don’t have good credit, it can be challenging to qualify for a personal loan, or at least one with a reasonable APR. You might have the option of a secured personal loan, which is backed by collateral, such as your home or car. Secured loans can be risky, though, since you could lose your collateral if you fall behind on payments.
Similar to a credit builder loan, your payments on a personal loan are reported to the credit bureaus. On-time payments will help your credit score, while late or missed payments will drag it down.