What is the purpose of a credit-builder loan?

By ,
Ask a Lender
December 19, 2017


Key Points

The pros and cons of credit-builder loans

  • They are offered in small amounts and have relatively low interest rates.
  • In many cases, you may not gain access to the funds until you’ve repaid the loan.
  • On-time payments are reported to credit bureaus, helping to boost your scores.
  • Some financial stability, such as an established residence or job, may be required.
  • Borrowers who need quick access to cash aren’t good candidates.

There are many reasons for needing to improve your credit. Maybe you’re a young adult who has yet to establish a credit score, or you’re trying to raise your score after years of questionable spending habits.

Regardless of your circumstances, there are ways to improve your situation. One way is through a credit-builder loan, a financial tool offered by some banks and credit unions. Before applying, however, you should understand the ins and outs of these loan products, then weigh the pros and cons of tying up money as a way to build credit.

How does it work?

Credit-builder loans are available in relatively small amounts, typically between $500 and $1,500, although some lenders may let you borrow as much as $3,000. The annual percentage rates (APRs) on these loans are favorable compared to most credit cards or personal loans, often ranging from 5 percent to 12 percent.

When you get a credit-builder loan, you are generally expected to repay it in monthly installments within 12 to 24 months. The loan may be secured, meaning you’ll need to provide collateral like an existing savings account or certificate of deposit (CD) to protect the lender in case of default. On rare occasions, credit-builder loans are unsecured and require no collateral.

In most cases, the lender establishes a locked account and the borrower cannot withdraw funds until the loan is completely repaid. Sometimes, the funds are released incrementally as you pay down the loan amount. The lender reports your payments to the three major credit bureaus — Equifax, Experian and TransUnion — and on-time payments helps you establish or improve your FICO credit score. Note that late payments or defaults hurt your scores.  

At the end of the repayment period, the lender releases the loan proceeds along with accrued interest, and you may spend or save the money as you see fit. It’s a low-cost way to build credit. For example, an 18-month loan of $1,000 with a 5 percent APR has monthly payments of $57.79. And you’ll pay only $40.22 in interest over the life of the loan.

Is it a good idea?

Credit-builder loans, in general, are safe and sound methods to establish or improve credit. If you have no credit, you can expect to create a FICO score within about six months, and the initial score may be as high as 650 to 700. Borrowers with poor credit can expect to see their scores rise by 20 to 25 points over the life of the loan, although this is dependent on other factors. Any delinquencies or high ratios of credit utilization on other accounts can slow the growth of your credit score.

If you’re considering a credit-builder loan, you should have some financial stability. Credit unions, for example, may require you to be a member of their institution for several months or have no recent checking-account overdrafts. They may also look for borrowers with an established residence or employment history.

If you’re unemployed or have a lot of debt that hinders cash flow, taking out a loan may not be the best idea. Understand the interest rate and monthly payment, and make sure on-time payments will be reported to the credit bureaus. Set up an automatic transfer if you’re worried about paying on time. And although most credit-builder loans don’t have prepayment penalties, don’t repay the loan early. Building credit takes time and if you do it right, you should be able to qualify for other types of loans and lines of credit in the near future.

Credit-builder loans can be good alternatives to secured credit cards. But people who need the loan proceeds right away aren’t good candidates. In these cases, you may need to search for an unsecured personal loan, which may have an interest rate up to 36 percent, the limit allowed by law in many states.

Keep in mind that community banks and credit unions that offer credit-builder loans are looking to create long-term customers. As they help you achieve good credit and financial stability, you’re more likely to borrow larger loans and help them make more money in the future.

Compare Personal Loan Lenders