Credit Builder Loan vs. Personal Loan - What's the Difference?

Building credit can feel like an uphill battle. Whether you recently moved to America and are starting over or you’ve lived here all your life and never established credit, it’s hard to build credit without credit.

Here’s how it works — because you don’t have a history of credit, companies categorize you as a “risky borrower” and as a result, you’re not able to get credit and prove them wrong. It’s a vicious cycle.

In fact, according to a study from the Consumer Financial Protection Bureau, 26 million Americans were “credit invisible,” or did not have credit records with nationwide credit reporting agencies. There are also 19 million Americans who are “unscorable” because they did not have enough credit history.

Whether you’re trying to buy a house, lease a car, rent an apartment or simply have access to a credit card, it's much harder to do without good credit. Here’s the good news, though — whether you’re “credit invisible,” “unscorable” or simply trying to raise your credit score, you have options.

In fact, there are several products that could help improve your credit, including either a credit builder loan or a personal loan. But first, it’s important to understand the differences between these two loans and which one makes the most sense for you.

Here’s everything you need to know about credit builder loans vs. personal loans.

What is the difference between a credit builder loan and a personal loan?

There are a few differences between credit builder loans and personal loans — interest rates, approval process, which financial institutions offer them and more — but the biggest difference is when you get the money.

Credit builder loans have one purpose: to help build your credit. Because of that, the loan process is different. Instead of receiving a lump sum of money at the beginning and then paying it back throughout the loan term, credit builder borrowers pay the loan first and then receive the money at the end.

It might sound counterintuitive since a lot of loans (student loans, mortgage loans and personal loans) give borrowers the money at the beginning, but by flipping the process, credit builder loans offer some unique advantages like lower interest rates, no credit score requirements and a chunk of savings at the end.

But that’s not where the differences (or similarities) end. As Jeff Gitlen, Content Associate and Contributor at LendEDU, a financial products comparison platform, explains, these loans are actually considered the same type of credit and both can help you build credit.

“Both credit builder loans and personal loans can help build credit. They are both considered installment debt and will appear on your credit report. If either is paid back diligently, it should have a positive impact on your credit history,” Gitlen says.

Credit builder loan

If you’re trying to build (or rebuild) your credit history, a credit builder loan is a great option. Some credit unions or other financial institutions will call them share-secured loans or CD-secured loans.

Here’s how credit builder loans work:

“The borrower begins making small monthly payments for a predetermined amount of time. Loan terms can be as short as six months or as long as six years. Once the loan balance reaches zero, the service provider unlocks the CD in which the money has been stored and returns the total money the borrower paid, minus any interest and administrative fees.”

Basically:

1. The lender sets aside a set amount of money in a Certificate of Deposit (CD) that’s equal to the loan amount.
2. Since it’s an installment loan, you make monthly payments (with interest) to pay down the loan balance.
3. Once you’ve paid off the loan, the money in the CD unlocks and comes back to you.

How to qualify

The application process for credit builder loans varies based on the lender, but is usually pretty straightforward. You’ll typically need a bank account, debit card or prepaid card and proof of identity.

This normally involves a credit check, but if you have no credit history, many lenders will work with you to confirm your identity in a different way. Some lenders, for instance, will use ChexSystems instead, which is a nationwide specialty consumer reporting agency under the Federal Fair Credit Reporting Act. Sometimes, the lender will ask security questions to verify your identity.

But as Gitlen explains, there is a big difference when it comes to qualifying for a credit builder loan versus a personal loan.

“Credit builder loans do not require good or great credit for approval, but proof of income is sometimes still required. Personal loans emphasize good to excellent credit as well as proof of income. You can still qualify for a personal loan with bad credit, but the interest rate may be much higher and chances of approval decrease.”

In other words, it’s often easier to get approved for a credit builder loan with favorable terms than it is to get approved for a personal loan with favorable terms, especially if you have bad credit or none at all.

Interest rates

As with most loans, interest rates vary for credit builder loans, but according to Gitlen borrowers have a better chance of securing a lower rate with a credit builder loan, especially since the loan amounts tend to be smaller.

“According to most sources, credit builder loan interest rates are typically lower than 10%, but of course, these rates can be higher depending on the lender and applicant’s eligibility. A credit-builder loan is secured, so there’s a better chance for a lower rate,” Gitlen says.

Pros and cons of credit builder loans

Credit builder loans offer unique advantages. Here are some pros and cons of using a credit builder loan:

__Pros: __

Here are some positive aspects of a credit builder loan:

• No credit score requirement: Borrowers do not need a certain credit score to be approved for credit builder loans. In fact, many lenders (including Self) do not require any credit history at all.
• Good habits: Because the money is basically being stored in a savings account, you’ll learn good financial discipline and create habits that will serve you in other areas like saving, investing and paying back debt. Paying the loan each month on time and in full can also help build positive payment habits.
• Lower interest rates: Compared to other loan types and credit cards, credit builder loans usually have much lower interest rates.
• No hard credit inquiry: Most lenders do not require a hard credit pull to qualify. This is good news for your credit score since hard pulls can cause a temproary dip in your score.
• No security deposit: In most cases, credit builder loans do not require you to pay a security deposit, because of the security offered by the CD.

Cons:

Like most things in life, credit builder loans have potential disadvantages as well. These are some things you might want to consider.

• Impacts credit score: It’s important to note that credit builder loan payments are reported to credit reporting agencies. This is good news if you’re trying to build credit and you make your payments on time and in full, but it also means that late or missed payments are reported as well, and they might negatively affect your credit.
• Fees: Like most financial products, credit builder loans do have administrative fees. These fees are usually reasonable, but should be factored into your decision.

Personal loans

If you need access to money for a big purchase or to consolidate debt, a personal loan might be an option. Whether a personal loan is right for you depends on your situation and ability to repay.

Here’s how personal loans work:

Personal loans are unsecured loans, which means that they are not connected to a physical object like a car loan or mortgage loan. This means that the lender does not have access to collateral if the borrower were to default (not pay) on the loan. As a result, personal loans tend to have higher interest rates.

How to qualify

In order to apply for a personal loan, you’ll need basic proof of identity, proof of income and a credit check.

According to Gitlen, it’s possible to qualify for a personal loan with bad credit.

“It’s possible to get a personal loan when your credit score is 500 or 600, but it’s just much, much harder in general. If you have high income, there is a better chance of getting approved for a personal loan despite having bad credit. Additionally, there are lenders who specialize in offering personal loans to consumers with bad credit. So you can try to compensate for bad credit by finding a lender willing to take a risk or by banking on income carrying the application.”

Interest rates

But even though you might qualify for a personal loan, it might not make sense to move forward with it. Interest rates for personal loans can fluctuate drastically based on the applicant’s creditworthiness.

Gitlen explains:

“Keep in mind that bad credit won’t do you any favors, even if you get approved. Personal loan rates can range up to 36% or higher, and a bad-credit applicant can expect to see higher rates and a more expensive loan.”

Where to get a personal loan

It’s a good idea to shop around for all types of loans, but it’s especially important for personal loans because the interest rates and terms can differ drastically.

In order to make sure you get the best terms, it’s smart to compare different lenders. You can apply online and get pre-qualified in a few minutes.

Pros and cons of personal loans

Like most things in life, personal loans have unique advantages and disadvantages. Here are some things to note:

Pros:

Here are a few positive aspects of personal loans:

• Quick and easy: For the most part, personal loans are easy to get. Plus, you’ll usually get the money fast.
• Flexible: You can use personal loans for anything. This is good news for people who need money for projects or items that other loans won’t cover.
• Build credit history: Like credit builder loans, if you make your payments on time and in full each month, you can usually build credit history by paying back personal loans. Be sure to ask the lender whether they report payment history to the credit bureaus.

Cons:

Even though personal loans have benefits, there are also negative aspects that you should be aware of.

• High interest rates: Interest rates can range from 5% for borrowers with excellent credit to 36% for borrowers with poor credit. If you’re trying to build credit with a personal loan, you’ll probably get a high interest rate, which means more money out of your pocket.
• Bad habits: Personal loans give flexibility but if you aren't disciplined they could lead to more financial challenges. Because you get the money quickly and don’t have to work or save for it, personal loans could result in a higher chance of spending the money first and not being able to pay it back later.
• Credit history: Borrowers must have credit history in order to qualify. For people without a history of credit, this might be a dealbreaker.

And in the case of “payday” loans, your interest rate could be closer to 300% or more.

Are there other options?

There are other options for building credit, but they come with their own advantages and disadvantages. Here’s what you need to know about other options.

Payday loans

Even though payday loans technically fit into the “personal loan” category, they have a bad reputation for trapping consumers in a never-ending cycle of payments that borrowers can’t pay until their next paycheck, according to Mike Brown, Research Analyst at LendEDU. They also have incredibly high interest rates compared to traditional personal loans. Plus, they typically don’t help build credit.

“Payday loans do not usually show up on your credit reports with Experian, Transunion, or Equifax. However, smaller specialized credit reporting agencies may collect this data which can be taken into account by certain lenders in future credit applications. So a payday loan may still help or hurt your credit, especially when it comes to applying for new credit, but they may not actually be reflected in your standard report,” Brown says.

Credit cards

In addition to payday loans, credit builder loans, or personal loans, you can build credit by using credit cards.

Brown explains:

“The most orthodox alternative is to apply for a secured credit card. Secured credit cards are designed for low- or no-credit consumers. They are secured by a cash deposit, and consumers can take advantage of a line of credit up to the credit limit.”

There are five major factors that determine your credit score, including credit mix. That means having both installment loan(s) and credit card(s) can help your credit score.

Andrew Rombach, Content Associate and Editor at LendEDU, explains:

“[Loans] and credit cards are considered different types of credit. A personal loan is installment credit, while a credit card is a revolving credit account. Either can help you build credit, and having both may even be considered a good sign by showing a mix of credit on your report.”

Many people who have no credit history or who have bad credit have a hard time getting approved for a credit card. If you're in that situation a secured credit card may be a good option.

How to get started building credit

Before you get started, the most important thing to do is find your purpose.

• If you’re trying to build credit or improve your score, a credit builder loan makes a lot of sense.
• If you need access to cash for a large project or to consolidate debt, a personal loan might be the best choice.

Once you’ve determined your “why,” Gitlen advises consumers to shop around for the best lender with the best loan terms.

Companies such as LendEDU and Nerdwallet compare financial products from various verticals such as personal loans, student loans, credit cards and more. This provides better access to information because you can look at terms side-by-side which can help you make a better decision.

At the end of the day, it’s important to know your options and make the right decision for yourself.

About the author

Taylor Milam is a personal finance writer who has also written for Credit Karma, Chime, Acorns and Policy Genius, among others.