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What Are Credit Builder Loans and How Do They Work?
A credit builder loan is a financial tool that can help you build credit history when you have none. Offered by banks, credit unions and online lenders, credit building loans aren’t like other types of personal loans. You might consider using one if you’re looking for a way to establish good credit history but there are some important things to know about how these loans work.
What Is a Credit Builder Loan?
A credit builder loan is a type of installment loan that has a single purpose: to help the borrower build credit. These loans are typically designed for people who either have no credit, thin credit or poor credit.
Credit builder loans are different from traditional personal loans. When you take out a personal loan, you may do so to consolidate debt, pay for home repairs or improvements or cover another large purchase.
A credit builder loan, on the other hand, is usually a smaller loan that’s primarily intended to help you establish a positive payment history.
How Credit Builder Loans Work
Normally, when you get a personal loan or any other type of loan you receive a lump sum of money from the lender. You can then use this money as needed to pay for expenses or pay off debts.
Credit builder loans don’t work that way. You get approved to borrow a certain amount of money but instead of giving it to you, the lender holds it in a deposit account which may earn interest.
You then make payments to the lender each month, which can be reported to the credit bureaus. Once you’ve made the required number of payments, the lender releases the loan amount to you, along with any interest earned.
While you don’t get the money from the loan right away, you do get the benefit of your payment activity being reported to the credit bureaus. Payment history is the most important factor in FICO credit scoring models, which are used by 90% of top lenders in credit decisions.
Credit Builder Loan Pros and Cons
If you’re interested in using a credit builder loan, it’s important to weigh the potential advantages and disadvantages.
- Credit builder loans can help you build positive credit history
- It may be easier to qualify for a credit builder loan with thin credit or no credit
- You can earn interest on the money you borrow
- The interest you pay on a credit builder loan may outweigh the interest you earn
- You don’t get access to loan funds until the loan is paid in full
- In addition to interest, you may also pay fees for a credit builder loan
Credit builder loans aren’t as flexible as regular personal loans, since you don’t get the money right away. And just like with other loans, missing a payment could hurt your credit score rather than helping it.
Other Ways to Build Credit
A credit building loan is just one possibility for establishing or build credit history. Here are some other ideas you might consider to improve your credit.
A personal loan allows you to borrow a lump sum of money that you can use for almost any purpose. As you repay the loan, those payments can be reported to the credit bureaus.
RELATED: Money Mistakes That Can Cripple a Credit Score
When exploring personal loan options, pay attention to:
- Interest rates and APR
- Loan repayment terms
- Loan fees
- Minimum credit score and income requirements
Also, consider whether a personal loan is secured or unsecured. Secured loans require collateral while unsecured loans do not.
A credit card is another way to establish and build credit. This is a type of revolving debt, which means you have a set credit limit you can make purchases against. As you make payments, you reduce your balance and free up available credit.
Credit cards can be useful for establishing credit if you’re paying on time each month and keeping your credit utilization low. Just like with personal loans, it’s important to compare the interest rate and fees you’ll pay for a credit card before applying.
Also, consider what else you may want from a credit card. Earning cash back on purchases, for example, could be a nice incentive to choose a rewards card over a plain vanilla card.
A third possibility for building credit is a savings-secured or share-secured loans. These loans, which you can find at banks and credit unions, let you borrow money using your savings account or certificate of deposit account as collateral.
With this type of loan, the bank or credit union temporarily freezes your savings. The money continues to earn interest but you can’t access it until the loan is repaid. In the meantime, your payments are reported to the credit bureaus.
Of these options, a personal loan could be the best fit if you need to borrow a larger amount of money. Comparing personal loan rates online can make it easier to see what different lenders are offering when choosing a loan. And you can also run the numbers with a personal loan calculator to estimate your monthly payments.
RELATED: Can You Get a Personal Loan With a Credit Score of 600?
Rebecca Lake is a freelance writer specializing in personal finance, credit and debt. She’s a contributor to U.S. News and World Report, Forbes Advisor and The Balance and her work has appeared online at CreditCards.com, MyBankTracker, Money-Rates.com and dozens of other top publications.