A credit-builder loan is designed to help people who have poor credit or 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. The amount you borrow is held in a bank account while you make payments.
How does a credit builder loan work to better your score?
A credit-builder loan can help build credit if you pay on time (or no more than 30 days late). Payments are reported to the three major credit bureaus, Equifax, Experian and TransUnion.
Making on-time payments on a credit-builder loan can help you improve your credit profile because the payment information in your credit reports is weighted more heavily than any other factor in calculating your credit score.
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.
Why do they do it? Financial institutions want to see you succeed. After all, if you become a customer, you’re more likely to make money for them in the future.
To make sure it doesn’t get burned on the loan, the lender will set strict limitations. Think of it as training wheels for credit.
How to get and manage a credit-builder loan
- Find a credit-builder loan. Look for ones with a payment level you can comfortably afford. Stretching your budget to make a higher payment won’t impress lenders more. NerdWallet recommends choosing a low one and a term no longer than 24 months.
- Apply for the loan. If you are approved, the money you borrow is deposited in a savings account that you typically can’t access until you have fully repaid the loan. This acts as a safety net for the lender that’s taking on risk if you have bad credit or no credit.
- Make payments on time, every time. If you pay the loan as agreed, the financial institution promises to send a good report to the credit bureaus. But a payment more than 30 days late can seriously hurt your score.
- Monitor your credit score. Personal finance websites such as NerdWallet offer free credit scores. NerdWallet’s scores are updated weekly. Don’t obsess over tiny movements, but look at the overall trend.
- Collect your loan proceeds, plus any interest. At the end of the loan term, you get the money — and likely a better credit score.
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. Capital Good Fund is a CDFI that makes small personal loans with rates that don’t exceed 24% APR, and offers a credit-builder program at an additional cost.
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.
Lending circles: One practice that can be used among families or friends is a credit-building plan offered through the Lending Circles program, which is run by nonprofit Mission Asset Fund. 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. 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 the 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.
Secured credit cards are another option. They can be very effective — but you first have to have enough money to pay the security 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 reputable lenders.
Some lenders who will grant you unsecured personal loans without checking your credit at all, but those installment loans are much more like payday loans. The lenders don’t check your credit, but they also don’t report to credit bureaus. And the loans carry interest rates that can easily reach 300% or higher.