What Is A Credit Builder Loan & How Does It Work?

A credit builder loan allows people with a bad credit report — or no credit history at all — to build positive credit history. Unlike some traditional loans, which are often unsecured, a credit builder loan works like an installment loan except you don’t get your money until you finish making all the loan payments. With this type of loan, holding onto the money until you complete all the payments helps to reduce the risk to the bank. If you are looking to build good credit, this post gives you the details on how a credit builder loan works, how to find them, and other options to help build a positive credit history.

Table of contents

• How does a credit builder loan work?
• How much does a credit builder loan cost?
• How do credit builder loans help build credit?
• Can credit builder loans hurt my credit?
• Where to find a credit builder loan
• Credit builder loan alternatives
• Looking for a credit builder loan?

How does a credit builder loan work?

A credit builder loan typically has four main phases, broken down below:

1. If approved for the loan, the loan amount you borrow is set aside in a secured savings account or certificate of deposit (CD) while you pay off the loan. Credit builder loans are typically $1,000 or less.
2. You begin making your monthly payments. Typically, you can expect the loan term — the amount of time for repayment — to be 6 to 24 months.
3. Your lender reports your payments to the credit bureaus (Experian, TransUnion and Equifax). Having your payments reported helps build your credit as long as you pay on time because payment history accounts for 35% of your FICO® score.^[1] It is an important factor when trying to build a good credit score.
4. At the end of the loan term, when the balance is paid off in full, you’ll have access to the money. You can deposit the money into your bank account and use the funds however you like. Keep in mind that any fees or interest that have been charged will be subtracted from your total final payment.^[2]

How much does a credit builder loan cost?

The cost of a credit builder loan can vary depending on the lender. Compare loan offers by considering the differences between these three main factors that affect the total cost of your loan:

• Administrative fees: Typically, you pay these fees upfront, and they can range anywhere from $9 to $15.
• Interest rate or annual percentage rate (APR): The interest rate refers only to the interest charged on the loan each year, but an APR includes both the interest and other fees to express the total annual cost of your loan. So if an APR looks high compared to another lender’s rate, check to be sure whether you’re comparing APRs or interest rates. If you’re comparing an APR to an interest rate, you’re comparing two different types of rates. Interest rates and APRs can range from 6% to 16%.^[3]
• Late fees: Missing a payment on your credit builder loan means you will be charged a late fee. Fees for late payments may be a percentage of the monthly payment added to what you already owe.^[2]

Credit Builder Loan Example

To help you understand how a credit builder loan works and the costs associated with one, we walk you through a hypothetical example that illustrates the process of applying for one:

1. Say you apply for a loan of $840 at an interest rate of 14.70% and APR of 15.97% — common rates for people trying to rebuild or establish credit.
2. You pay a one-time, nonrefundable administrative fee of $9.
3. The monthly payment could be $35 per month, meaning you would need to pay that amount per month for 24 months.
4. As long as you make all of your payments on-time for 24 months,, you could get $724 back. — meaning the bank kept $116 in interest. In addition, you get a chance to build positive credit.

Important: Keep in mind the interest rate is different from the APR, because APR calculates the total cost of borrowing money including interest rate and fees, whereas the interest rate is just the percentage of the loan you’re charged for.^[3]

How do credit builder loans help build credit?

A credit builder loan may be a good option for you if you need to build credit but can’t qualify for a traditional loan. Credit builder loans can help you build healthy money habits as long as you make payments on time, which can affect your payment history. However, missing a payment could make your credit even worse, so be careful.^[2]

These loans can have a positive impact on those who take them out and faithfully make payments. The Consumer Financial Protection Bureau (CFPB) conducted research, for which enrollment took place from September 2014 to February 2015, and released its findings in 2020. The CFPB research found that a credit builder loan increased the likelihood of establishing a credit score for participants without an existing loan by 24%. Those same participants saw their credit scores increase by 60 points more than participants with existing debt. Also, the credit builder loan resulted in an average increase in participant’s savings balance of $253.^[4]

However, for those who participated in the study and had existing debt, the credit builder loan seemed to have a negative impact on their credit scores. Those with existing loans had their scores impacted by a slight decrease, indicating that they may have experienced difficulty making credit builder loan payments on top of their current obligations.^[4]

Can credit builder loans hurt my credit?

Credit builder loans can hurt your credit score if you miss payments or let the loan go into default. To help prevent damaging your credit, set a realistic monthly budget to ensure that you can make on-time payments and give yourself a better chance at building a positive credit history.^[5]

Where to find a credit builder loan

If you’re looking for a credit builder loan, there are a few places where you can find one. Four in particular will be your best bets.

• Online lenders: You can get credit builder loans from online lenders, which is often the easiest way to do it. One option to consider is the Self credit builder loan if you are looking for an online lender.
• Credit unions: Credit unions may also offer credit builder loans,.ou may need to become a member to apply. The advantage is that they often have low interest rates.
• Community banks: A traditional bank might offer these types of loans, but you may need to call a few banks, as most national and international banks don’t offer them.
• Lending circles: A fourth option is to try a peer lending circle. You may need to meet a number of requirements and be a member for a certain period of time.^[6]

Credit builder loan alternatives

If you’re not convinced that a credit builder loan makes sense for you, consider some of these alternatives from financial institutions.

Consider using a secured credit card

A secured credit card gives you access to a line of credit upfront in exchange for a security deposit usually in the form of a savings account or certificate of deposit that’s used as collateral. This deposit sets your credit limit. You still have to make monthly payments on purchases you make — the deposit doesn’t cover your monthly payment — so make sure you use this option responsibly to improve your credit, or you risk causing more damage to your credit history.^[7]

Become an authorized user

Another alternative to a credit builder loan, you can become an authorized user if you know someone who would be willing to add you to their credit card account. Becoming an authorized user can help improve or restore credit, as long as you and any other user continue to make on-time payments, the credit utilization ratio (CUR; the total balance of the card divided by the total credit limit) remains low and the account has been open for a while. Of course, you risk damaging your own and the other person’s credit if the converse is true: Your friend or family member makes late payments or none at all, the CUR is high or the account has been just recently opened.^[8]

Consider taking out a personal loan

A personal loan can also allow you to develop a positive payment history and have a mix of credit options on your report. Your credit mix accounts for 10% of your FICO® score, so if you add a new type of credit product to your history, you may see an impact on your score if you make on-time payments. If you handle a variety of credit products well, you show lenders that you may be a lower risk to lend to. Of course, because payment history accounts for 35% of your score, making on-time payments, or the lack thereof, can have the most impact on your score.^[1]

Although personal loans may sound like the perfect alternative, keep in mind that personal loans can have their downsides as well. Personal loans tend to charge a high APR (annual percentage rate), which represents the total cost of the loan, which includes the interest rate and applicable fees. Interest rates for personal loans may be fixed or variable interest rates, and those with lower credit scores may be charged a higher interest rate.^[9]

A fixed rate doesn’t change over the loan term, but a variable rate can change based on whatever index your lender uses to calculate rates. So what may look like an affordable rate can fluctuate over your loan term. So carefully consider the loan terms and how a variable rate could impact your monthly budget before taking on a loan with a variable rate that could go up and make your payments higher.^[10]

Looking for a credit builder loan?

If you think a credit builder loan may work for you, just remember the basic differences from traditional installment loans where you get a lump sum upfront and make monthly payments to pay the loan off. With credit builder loans, you make monthly payments to the lender who puts the money into a certificate of deposit (CD) or a savings account. Once you’re done making all the payments, the lender returns that money to you (minus interest and fees). With payments reported to the credit bureaus, not only do build savings, but making on-time payments may also help to elevate your credit score.

Once your Credit Builder Account* comes to a close, make an action plan to address the future of your finances. Think back to the initial goals you set when you began building credit. What is your “why”? To purchase a car? Or maybe buy a home in the future? Get started by writing down your financial goals on this template.

*Credit Builder Accounts & Certificates of Deposit made/held by Lead Bank, Sunrise Banks, N.A., SouthState Bank, N.A., First Century Bank, N.A., each Member FDIC. Subject to credit approval.

Sources

1. myFICO. “What's in my FICO® Scores?” https://www.myfico.com/credit-education/whats-in-your-credit-score. Accessed October 17, 2022,
2. Experian. "How Do Credit-Builder Loans Work?" https://www.experian.com/blogs/ask-experian/how-does-a-credit-builder-loan-work. Accessed July 5, 2022.
3. Experian. “Personal Loan Interest Rates and APRs: What’s the Difference?”
   “https://www.experian.com/blogs/ask-experian/what-is-the-difference-between-apr-and-interest-rate-on-a-personal-loan/. Accessed July 6, 2022.
4. Consumer Financial Protection Bureau. "CFPB Study Shows Financial Product Could Help Consumers Build Credit," https://www.consumerfinance.gov/about-us/newsroom/cfpb-study-shows-financial-product-could-help-consumers-build-credit. Accessed July 5, 2022.
5. Experian. "Can I Pay Off A Credit-Builder Loan Early?" https://www.experian.com/blogs/ask-experian/can-i-pay-off-a-credit-builder-loan-early. Accessed July 5, 2022.
6. Experian. "How Do I Get a Credit-Builder Loan?" https://www.experian.com/blogs/ask-experian/how-do-I-get-a-credit-builder-loan. Accessed July 5, 2022.
7. Experian. "What Is a Secured Credit Card?" https://www.experian.com/blogs/ask-experian/what-is-a-secured-credit-card. Accessed July 5, 2022.
8. Experian. "Will Being an Authorized User Help My Credit?" https://www.experian.com/blogs/ask-experian/will-being-an-authorized-user-help-my-credit. Accessed July 5, 2022.
9. Experian. "How Do Personal Loan Interest Rates Work?" https://www.experian.com/blogs/ask-experian/how-do-personal-loan-interest-rates-work. Accessed July 5, 2022.
10. Experian. “Fixed APR vs. Variable APR: What’s the Difference?” https://www.experian.com/blogs/ask-experian/fixed-apr-vs-variable-apr/#:~:text=Quick%20Answer,consumer%20credit%20and%20finance%20education. Accessed October 17, 2022.

About the author

Ana Gonzalez-Ribeiro, MBA, AFC® is an Accredited Financial Counselor® and a Bilingual Personal Finance Writer and Educator dedicated to helping populations that need financial literacy and counseling. Her informative articles have been published in various news outlets and websites including Huffington Post, Fidelity, Fox Business News, MSN and Yahoo Finance. She also founded the personal financial and motivational site www.AcetheJourney.com and translated into Spanish the book, Financial Advice for Blue Collar America by Kathryn B. Hauer, CFP. Ana teaches Spanish or English personal finance courses on behalf of the W!SE (Working In Support of Education) program has taught workshops for nonprofits in NYC.

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