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For people with no credit or limited credit history, credit-builder loans can be a great way to build their credit scores and their savings.
Credit-builder loans can help boost scores because payment history is an important credit scoring factor. On-time payments are reported to at least one major credit bureau — Experian, Equifax or TransUnion.
Once all the payments are made, the lender releases the full loan amount to the borrower, who can then use it as an emergency fund or to meet another savings goal.
Credit-builder loans are typically offered by smaller banks and credit unions. Most loans are between $300 and $1,000 with a term of 6 to 24 months. Details like annual percentage rate and fees will also vary.
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. When applying, you might need to provide information on your employment history, income and balance in your checking or savings account.
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. Your loan payments are reported to at least one major credit bureau but, ideally, you should look for loans that report to all three. Your credit scores are 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.
With a traditional loan, the borrower gets the money first and pays it back over time. With a credit-builder loan, the lender keeps the total loan amount while the borrower makes payments. Once all the payments have been made, the borrower receives the full loan amount.
Keeping up with payments on your credit-builder loan is crucial because it shows you can handle a credit account. FICO and VantageScore pay the most attention to your payment history when compiling scores.
You typically can’t access the money until you have fully repaid the loan, which demonstrates to the credit bureaus you can make on-time payments. This also acts as a safety net for the lender that’s taking on risk if you have no experience with credit or a low credit score. Another benefit of a credit-builder loan? At the end of the loan's terms, you'll have a reserve of funds that can serve as an emergency fund or go toward another important savings goal.
Who benefits the most from credit-builder loans?
Credit-builder loans can help people who are "credit invisible," meaning they don't have a credit score, get on the scoring radar and can be a good choice for credit newbies. A Consumer Financial Protection Bureau analysis of about 1,500 consumers, released in 2020, found that 1 in 10 adults in the U.S. are credit invisible — that's more than 26 million Americans.
While people who are credit invisible can use debit cards or cash, they have limited access to financial products and services, which can pose real obstacles as they try to purchase a car or home or get approved for a credit card or apartment lease.
Consumers with existing debt are not likely to see as much benefit from credit-builder loans, because they typically have credit scores already. The credit scores of consumers in the CFPB analysis who did not have existing debt went up 60 points more than those who had existing debt.
How to choose and manage a credit-builder loan
Research and compare lenders. Look for a credit-builder loan with a payment and term you can comfortably handle. Stretching your budget will only raise your risk of missing a payment and damaging your scores. Choose a loan that reports payments to all three major credit bureaus, if possible.
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 scores.
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.
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 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 credit-builder loans
Credit unions or community banks: Finding a credit-builder loan can be tricky. One way to look is to search online for “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 specific 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 1,400 of them in the United States.
Online lenders: An online search can bring up lenders that offer credit-builder loans. Not every lender is licensed in every state, though, so it's important to check that. In addition, payments, terms and APRs vary widely.
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. Availability is limited. 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's 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. The primary user doesn'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.
Should you use a personal loan to build credit?
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 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.