What is a Credit Builder Loan?

ByG. Dautovic
February 09, 2022

If you want to borrow money without having to pay hefty interest, you need good credit. Having a high score signals to lenders that you’re “good for the money.” In other words, you can pay them back. 

Unfortunately, your credit score might not be where you’d like it to be. That’s where a so-called credit builder loan can help. These innovative financial devices allow you to quickly build your credit score at a low cost.  

What Is a Credit Builder Loan?

A credit builder loan is a financial tool designed to improve your credit score. Lenders set up repayment schedules on the money you borrow and then use repayments as evidence of your creditworthiness. Because of this, such loans are extremely beneficial for those with no credit score or low credit scores who can’t get loans through conventional channels. 

To obtain a credit builder loan, you’ll need to go to a community bank or credit union. Mainstream financial institutions generally don’t offer them. 

How Does a Credit Builder Loan Work?

Compared to other loan types, how credit builder loans work is a little odd. That’s because you don’t get direct access to any money you borrow. Instead, the lender sets up a loan for you and then deposits the funds in a bank account they control. You then make payments towards the loan, including interest. 

At the end of the process, the lender returns the principal to you – the amount they deposited in the account – in exchange for interest payments. The lender then reports your progress to credit bureaus. 

There are two significant benefits of credit builder loans. Firstly, they improve your credit score. On seeing that you made successful payments, credit rating agencies bump up your rating, making it cheaper for you to borrow money in the future. 

Secondly, they let you build a nest egg. Paying off a loan is like making regular savings contributions while improving your score simultaneously. 

How To Manage a Credit Builder Loan

Managing a credit builder loan requires the following: 

Choosing the Type of Credit Builder Loan

Larger loans can result in more dramatic improvements in your credit score. However, if you stretch your budget too much, you may not be able to meet minimum payments, or you’ll miss a payment, adversely affecting your credit rating. 

Always Paying on Time

Taking out a credit builder loan is a bit like putting yourself on financial probation. You need to prove that you can behave yourself to access conventional loans in the future. 

For this reason, treat credit builder loans like the real thing and always pay on time. Late payments could harm your credit score more than never opening such an account in the first place.

Checking Your Progress Regularly

With all the effort involved in taking out and paying off credit builder loans, you want to ensure that you're making good progress. Regularly check in with credit rating agencies to see if your credit score is improving. 

Figuring Out What To Do With the Loan Proceeds 

Once you’ve finished paying the loan, the lender will return the principal to you. It’s then your job to figure out what to do with it. The best strategy is to invest it so that you can begin generating a passive income stream to support your regular wages. 

Finding a Credit Builder Loan

There are several places you can go to find a credit builder loan. Lenders that offer credit builder loans include:

Community Banks and Credit Unions

As discussed above, community banks and credit unions are purveyors of credit builder loans. However, you may have to fulfill various membership requirements to access their services. These might include living in a particular area, attending a specific religious venue, or working at selected companies. 

But while entry requirements can be high, they are also diverse, meaning that you can usually find a lender that fits your lifestyle. Once you’re signed up, you’ll benefit from the lowest interest rates, making their credit builder loans among the most affordable loan types around.

Lending Circles

Lending circles are an ancient practice where a group of approximately ten people come together and all contribute money each month so that one or two people can take out loans. In the past, such lending circles didn’t communicate with rating agencies. However, there are now lending circle platforms that do, allowing you to improve your credit score without having to go to a commercial lender.

Online Lending Firms

If you search online for credit builder loans, you’ll discover a range of digital lenders willing to provide these services. If you’re in the US, make sure to check whether the lender has a license to operate in your state. Also, compare the lender's APR to other services in your area. You may find that the fees are higher than they need to be. 

Community Development Financial Institutions (CDFIs)

Lastly, you can approach a CDFI. These are organizations in low-income areas that provide credit builder loans and other financial services to the community. Currently, there are around 1,000 of them in the US. Like lending circles and community banks, they offer low rates of interest. However, they only cater to the most financially challenged individuals who might not qualify for a credit builder loan elsewhere, so only use them as a last resort. 

Costs of a Credit Builder Loan

How much a credit builder loan costs depends on your credit score and the type of lender you go to. Lenders break down costs in various ways. 

Most will quote an APR, which stands for “annual percentage rate” or how much it’ll cost you in interest to borrow funds for a year. Credit builder loans from reputable banks and credit unions should offer APRs below ten percent, but the amount of interest you pay will depend on the APR and the length of your loan term. 

Lenders may also charge other fees and costs. For instance, an application fee when you set up the loan for the first time, or penalty fees if you make late payments. 

Some loans have maximum and minimum limits. These protect borrowers from taking out too much money while encouraging them not to get into a loan agreement for a pittance.

Summary

Credit builder loans let you build savings and your credit score. The type of credit builder loan you take out depends very much on your circumstances and financial health. While paying a loan on time can help improve your credit score, failing to pay can also damage it, so you’ll want to make sure that you can make payments on a regular basis before taking out a loan.

FAQ

Is a credit builder loan a good idea?

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Credit builder loans are a low-risk way to build your credit score. What’s more, at the end of the process, the lender returns the principal to you, helping you create a nest egg for future investments or retirement funds.

How many points will a credit builder loan raise my credit score?

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People who take out credit builder loans and don’t have existing debt may be able to boost their credit score by up to 60 points. Some studies suggest that the boosts are more modest – around 32 points. However, borrowers can use credit builder loans as part of a group of tactics to boost their credit ratings.

Do banks offer credit builder loans?

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Most mainstream banks do not offer credit builder loans. However, local credit unions and community banks do.

Can you get a credit builder loan with bad credit?

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One of the benefits of a credit builder loan is that people with bad credit can take them out. Some lenders will even agree to give this type of loan to people with zero credit history because they have complete control over the capital. As such, a credit builder loan is one of the best loan types to consider when you have bad credit.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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