What Is a Credit-Builder Loan?

A credit-builder loan holds the amount borrowed in a bank account while you make payments, building credit.

Bev O'SheaOctober 27, 2020
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what is a credit-builder loan

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A credit-builder loan is designed to help people who have little or no credit history build credit. A good score makes approval for credit cards and loans, at better rates, more likely.

Credit-builder loans do not require good credit for approval. They do require that you have enough income to make payments.

These loans can be a good choice for credit newbies but may not be effective for those with existing debt. A Consumer Financial Protection Bureau analysis of about 1,500 consumers, released in 2020, found that "participants without existing debt saw their credit scores increase by 60 points more than participants with existing debt."

How does a credit builder loan work?

Credit-builder loans go by many names, such as "Fresh Start Loans" or "Starting Over Loans." They're not widely advertised and are generally offered by smaller financial institutions, such as credit unions and community banks.

If you are approved for the loan, the amount you borrow is held in a bank account while you make payments. You typically can’t access the money until you have fully repaid the loan, which means you are able to build savings and your credit at the same time. This also acts as a safety net for the lender that’s taking on risk if you have no experience with credit or a bad credit score.

Your loan payments are reported to at least one credit bureau. Your credit score is built from information in your credit reports, which the three major credit bureaus compile. Having your payments reported helps build your credit as long as you pay on time.

Keeping up with payments on your credit-builder loan is crucial because it shows you are able to handle a credit account. Credit scoring models FICO and VantageScore pay the most attention to your payment history in your credit reports.  

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How to manage a credit-builder loan

  1. Pick the right type of credit-builder loan. Look for one with a payment you can comfortably afford. Stretching your budget will only raise your risk of missing a payment and damaging your score. NerdWallet recommends choosing a manageable loan amount and a term no longer than 24 months. Choose a loan that reports payments to all three major credit bureaus.

  2. Make payments on time. If you pay the loan as agreed, you build up good data on your credit reports. But a payment more than 30 days late will also go on your reports and can seriously hurt your score.

  3. Monitor your credit score. Use a personal finance website such as NerdWallet to get a free credit score. NerdWallet updates your score weekly; watch the overall trend of your score, but don’t obsess over tiny movements.

  4. Decide what to do with your loan proceeds, plus any interest. At the end of the loan term, you get the money — and likely a better credit score. If possible, use that money as an emergency fund. Having even a few hundred dollars saved can insulate you from unexpected expenses that otherwise might lead to debt or missed payments and score damage.

Where to find a credit-builder loan

Credit unions or community banks: Finding a credit-builder loan can be tricky. One way to look is to search online for your state plus “credit builder loan.” You may find credit-builder loans available at nearby community banks or credit unions. Credit unions typically have membership requirements, such as living in a particular county, working for particular companies, worshiping in a certain church or making a small charitable donation. But they may offer the lowest interest rates. It pays to check.

CDFIs: If your credit union or community bank doesn’t offer them, you might try a Community Development Financial Institution. These organizations exist to help lower-income communities, and there are about 1,000 of them in the United States.

Online lenders: Self (formerly Self Lender), for instance, offers loans with payments starting at $25 a month for a two-year loan. Interest rates are below 16%, and payments are reported to the three major credit bureaus. Kikoff is another online lender that makes interest-free loans of $12, which you pay back over a year.

Lending circles: One practice that can be used among families or friends is a credit-building plan offered through lending circles. The nonprofit Mission Asset Fund runs a lending circle program. Participants get interest-free “social” loans, with payments reported to credit bureaus. They are not available everywhere; you can plug in your ZIP code to see if there is one in your community. Other companies also offer versions of lending circles.

In such groups, about 10 participants each agree to put in a certain amount per month, and the money goes to one person, in a round-robin fashion, each month until everyone has received a pot of money.

Other options for building credit

  • If you have money in the bank, you may have another option for an installment loan: a share- or certificate-backed loan. In that case, a deposit you already have at the financial institution is the collateral, and that money is frozen until the loan is repaid (or it may be incrementally thawed, as the loan is repaid). So if you have funds on deposit at a small bank or credit union, it may be worth asking if you can borrow against them to help reestablish your standing. Other lenders may allow you to borrow against the value of your car.

  • If it is an option, you could also ask a friend or relative who has excellent credit to add you as an authorized user on a credit card. As an authorized user, the account history of that card will be added to your credit report. They don't have to actually give you the card, and you don't need to make charges — just being associated with their stellar credit reputation helps yours.

  •  Secured credit cards are another good option to build credit, but they require an upfront deposit, typically starting at $200. You can also explore alternative credit card products that do not require a deposit.

If you are trying to build credit and need the proceeds of a loan immediately (for debt consolidation, for example), you will probably need to take an unsecured personal loan. That means the lender has no collateral, just the strength of your credit history, to rely on. If your credit is damaged or thin, you’ll pay higher interest rates, sometimes as much as 36%, which tends to be the ceiling with most personal loan lenders that check credit.

Some lenders who will grant you unsecured personal loans without checking your credit at all, but those installment loans work much more like payday loans. The lenders may not report payments to credit bureaus, which means they are not useful if you are trying to build credit.

What's next?

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