What is a credit-builder loan?

A credit-builder loan is designed to help you establish or improve your credit score. Unlike traditional loans where you receive the borrowed money upfront, you receive money from a credit-builder loan after you’ve finished making payments on the loan. 

If you’re one of the 16% of consumers with bad credit, according to Experian, getting approved for a loan can be tough. While a credit- builder loan won’t get you money now, it can help you get money you’ll need in the future — perhaps for a new car, emergency expenses, or a home. As long as you make payments on time, this type of loan is a proactive way to build a credit history and improve your credit score.

How does a credit-builder loan work?

A credit-builder loan is designed for borrowers with no credit or bad credit (a FICO score below 580). In most cases, it’s a small loan with a short repayment term ranging from six months to two years, depending on the lender.

Just like with a traditional installment loan, you’ll make monthly payments, which include principal and interest, throughout your loan term. The lender will then report your payment history to the major credit bureaus. However, not every lender reports to all three credit bureaus, so it’s a good idea to find lenders that do. Making timely payments can help you establish or improve your credit score.

Unlike with a traditional loan, your money will be kept in a dedicated savings account or certificate of deposit. Once your term is up, the lender will grant you access to the funds, minus interest and fees. However, some lenders may give you interest back. For example, Alltru Credit Union will give you half of your interest payments back as long as you made all of your payments on time during the life of the loan.

Example of a credit-builder loan

Let’s say you get a credit-builder loan for $800 with a 12% annual percentage rate (APR) and a term of one year. There's no origination fee or other upfront fees, so you make 12 monthly payments of roughly $71, including interest. Once the loan is approved initially, the lender will move $800 to a locked account while you make your payments.

Once your term is up, you’ll have access to the loan funds and a credit history of 12 on-time payments.

You can estimate monthly payments using a personal loan calculator. Just enter in the amount, interest rate, and terms to see your estimate. 

Credit-builder loan availability

Credit-builder loans are typically available at a community bank or credit union, but are more common through online lenders that specialize in them. Self, MoneyLion, and Fig Loans are a few examples of lenders that offer credit-builder loans.

How long does it take for my credit score to change?

There’s no set timeline for seeing positive changes in credit scores. The amount of time it takes to improve your credit score depends on your credit situation and what’s hurting it. There are factors used by credit scoring models, such as FICO or VantageScore, to calculate your credit score. Each scoring model may weigh these factors slightly differently, resulting in variations in your scores between different models. 

Here’s how FICO weighs them:

• Payment history (35%): The largest factor influencing your credit score is your payment history. This includes whether you've paid your bills on time, any missed or late payments, and if you've had accounts sent to collections or bankruptcies.
• Amounts owed (30%): This factor looks at how much debt you have, including how much of your available credit you're using (credit utilization). Keeping your credit utilization ratio on revolving accounts low, ideally below 30%, can positively impact your credit score. It's calculated by dividing your total credit card balances by your total credit limits. .
• Length of credit history (15%): The length of time you've had open credit accounts influences your score. Generally, a longer credit history is seen as more favorable, as it provides a more extensive track record of your borrowing and repayment behavior.
• Credit mix (10%): Lenders like to see that you can responsibly manage different types of credit accounts, such as credit cards, installment loans (like mortgages or auto loans), and retail accounts. Having a diverse mix of credit can positively impact your score.
• New credit (10%): Opening several new credit accounts in a short period can represent higher risk, especially if you don't have a long credit history. Each time you apply for credit, it generates a hard inquiry on your credit report, which can temporarily lower your score.

It may take anywhere from a few months to a few years to build credit, so it’s important to be patient and persistent.

Pros and cons of credit-builder loans

Pros

• Easy to qualify for: Compared to a traditional loan, a credit-builder loan has lenient requirements. You may be able to get approved quickly, even if you have no credit or bad credit.
• Reported to credit bureaus: A credit-builder loan will show up on your credit reports. As long as you make timely payments, it can help you build your credit over the term of the loan.
• Can help with financial goals: At the end of the term, the lender will return your money, minus interest and fees. You can use these funds to build an emergency fund or meet any other financial goal.

Cons

• You have to wait: You’ll receive your money at the end of the term, instead of after you get approved like you would with a traditional loan. This can be an issue if you need fast cash.
• Interest and potential fees: You’re basically paying a lender in order to save your own money (and build your credit). Interest rates for credit-builder loans can range from 5% to 16% or higher, depending on the lender. 
• Can hurt your credit: If you miss your payments, a credit-builder loan can hurt, rather than help, your credit score. Avoid taking one out unless you’re confident you can stick to your repayment schedule.

How to get a credit-builder loan

Follow these steps to apply for a credit-builder loan:

1. Know your credit situation: Visit AnnualCreditReport.com to pull free copies of your credit reports weekly. Dispute any errors or inaccuracies with the appropriate bureau.
2. Shop around: Do your research and find at least a few lenders that offer credit-builder loans. Then, compare borrowing amounts, interest rates, and fees to zero in on the best option. Also prequalify with personal loan lenders to see if you can qualify for a loan that send money upfront.
3. Complete your loan application: Most lenders perform a hard credit pull once you submit your application, which can lower your score temporarily. But not every lender does this for a credit-builder loan. Be prepared to share details about your employment, income, savings, and any debts.
4. Close on the loan: Upon approval, read and sign the loan agreement. Then, make on-time payments until your term is up.

Managing a credit-builder loan

Here are some tips to help you manage a credit-builder loan:

• Make timely payments: Be sure to make on-time loan payments every month. Otherwise, you may face late fees and damage your credit. Consider setting up autopay if available so you don’t miss any payments.
• Use the funds wisely: When you get your money back from a credit-builder loan, pay off debt or build an emergency fund. This can help you improve your financial situation and free up funds for fun items, like a vacation or new furniture.
• Monitor your credit: There are many credit monitoring services available through credit card companies, banks, credit unions, and independent providers. Take advantage of them so you know whether you’re making progress.

Other ways to improve credit

If you decide that a credit-builder loan doesn’t make sense for you, you might want to explore these alternatives to help build your credit.

• Personal loan: If you have good credit (usually defined as a FICO score of 670 or higher), you may be able to get a low rate on a personal loan. But even with bad credit, some lenders like OneMain Financial, Avant, and Universal Credit will consider your application. 
• Secured personal loan: A secured personal loan is tied to collateral, like your house or car, while an unsecured personal loan is not. Interest rates for personal loans can range from 6.99% to 35.99%, depending on the lender. 
• Secured credit card: A secured credit card works like a traditional credit card. But it also requires a refundable deposit, which is usually the same as your credit limit.
• Certificate-secured loan: Issued by a credit union, a certificate-secured loan is a type of loan that’s backed by the money you have in a savings account or share certificate. You won’t be able to access the funds while the loan is active.
• Become an authorized user: When you become an authorized user on another person’s credit card, that card and payment history is added to your credit report. As long as the primary cardholder is responsible with their card (and you are as well), this strategy can help you improve your credit.

FAQ

What is the minimum credit score required for a credit-builder loan?

A credit-builder loan is designed for borrowers with no credit or bad credit. There are usually no minimum credit score requirements.

Can I get a credit-builder loan if I have a bankruptcy on my record?

You may be able to take out a credit-builder loan even if you’ve gone through bankruptcy. Most lenders have flexible requirements and are open to borrowers with negative marks on their credit.

How long does it take to build credit with a credit-builder loan?

Your particular credit situation will determine how long it takes to build credit with a credit-builder loan. It may be anywhere from a few months to a few years, so patience is key.

Can I pay off a credit-builder loan early without any penalties?

As long as a credit-builder loan doesn’t come with a prepayment penalty, you can pay it off early without incurring a fee. Fortunately, most credit-builder loans don’t have prepayment penalties.