If you’re interested in getting a car loan or buying a home, one thing lenders will consider is your credit score. Your credit score influences whether you’ll be approved for a loan and the interest rate you’ll pay. Getting any kind of loan when you have a thin credit file or no credit at all can be difficult—but it’s not impossible. A credit-builder loan may help you establish good credit with sound repayment habits.
What Is a Credit-Builder Loan?
When you visit the bank for a personal loan, you fill out an application, sign some forms, and walk away with the cash. The idea is to deliver money to the borrower and an interest-paying customer to the bank.
A credit-builder loan, on the other hand, emphasizes building credit first and borrowing second.
With this type of loan, you’re approved to borrow a certain amount of money. But instead of giving you the cash, the lender puts that money into an interest-bearing savings account for you. You repay the loan over time, with interest. Once the loan is repaid in full, the lender releases the money held in the account to you, along with any interest earned. The lender may even refund some of the interest you paid. Along the way, the lender reports your payment history to the major credit bureaus, allowing you to build your credit score.
Credit-builder loans are sometimes grouped together with share-secured or savings-secured loans. With these types of loans, you give the bank or credit union money from your savings account as collateral for a loan. That money is then held in an interest-bearing account. You repay the loan and get your savings back, with interest, at the end of the loan term. This is also a way to build credit; the key difference between share- or savings-secured loans and credit-builder loans is that credit-builder loans typically don’t require you to offer your savings as collateral.
How Credit Builder Loans Improve Credit History
For a credit-builder loan to work, payments must be on time and those payments must be reported to the credit bureaus. Payment history accounts for 35% of FICO credit scores, the scores which are used by 90% of top lenders in making credit decisions. On-time payments help to establish and build good credit, while late or missed payments can harm a credit score.
According to one credit builder lender, the average FICO credit score amongst its users who made every loan payment on time rose by almost 70 points after one year with such an account.
Before agreeing to a credit-builder loan, borrowers should check with the lender to make sure that payment history is reported to the credit bureaus. It’s important to keep in mind that lenders aren’t required to report your payment history. And if a lender does report payments on a credit-builder loan, they may not report to all three major bureaus—Equifax, Experian, and TransUnion.
That’s important to know because you don’t just have one credit score. Each credit bureau issues credit scores based on the information it has on file. So if you get a credit-builder loan and your payment history is only reported to one credit bureau, you might end up with a higher credit score from that bureau compared to the other two.
Credit Builder Loan Costs
Credit-builder loans are meant to help borrowers build their credit, but they’re not free. Lenders charge interest on these loans, which will vary, depending on the amount borrowed and the length of time. A lender might also charge fees such as application fees or loan origination fees. Any fees can be rolled into your loan payments, although some lenders may require you to pay them upfront.
Also, be aware of whether a credit-builder loan involves a prepayment penalty. A prepayment penalty is a fee lenders can charge when you pay a loan off ahead of schedule. The fee allows them to recoup any lost interest charges they might miss out on by you paying the loan off early.
Applying for a Credit Builder Loan
The first thing you’ll want to do before applying for a credit-builder loan is to check your credit. Reviewing your credit gives you some insight into what a lender will see when they check your credit during the application process. This can help you narrow down which loans you may be best able to qualify for and gives you an idea of the interest rate you might pay for a credit-builder loan. Next, compare your options for credit-builder loans.
You can find these loans through banks, credit unions, and online lenders. As you review loan options, focus on:
- How much you can borrow
- Whether collateral is required for a loan
- Whether the lender performs a hard or soft credit check
- Loan repayment terms
- Loan fees
- Interest rates
- Minimum credit score or income requirements to qualify
Applying for a credit-builder loan is similar to applying for any other type of loan for the most part. You’ll need to give the lender your name, address, phone number, Social Security number, and date of birth. They may also ask about your employment history, income, debt obligations, and how much you have in savings.
Credit-builder loans can be an effective way to build credit if you’re making payments on time and those payments are being reported properly. They can also be a less expensive option in terms of the interest rate, compared to a secured or traditional credit card. If you’re considering a credit builder loan, remember to:
- Assess your borrowing needs
- Consider your likelihood of qualifying for a loan
- Shop around for the best loan terms
- Choose a loan with a payment amount that's reasonable for your budget
- Check your credit regularly after getting the loan to monitor your credit score progress