Credit-Builder Loans: What They Are and When They Make Sense

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Figuring out how to build credit can be a mystery to those who don't understand how credit works. Thankfully, there are ways you can build credit even if you have a poor credit score. One way to work on building your score is to take out a credit-builder loan. If you haven't heard of a credit-builder loan, you aren't alone. Here's what they are and how they work.

How Do Credit-Builder Loans Work?

The term "credit-builder loan" refers to a few types of loans that help improve your credit score if you have a thin credit file or generally poor credit. The lender will report your loan payments to the credit bureaus, which should boost your credit as long as you make all of your payments on time.

In a traditional credit-builder loan, the creditor loans you money that is immediately put into a savings account. Because the money is locked away, this type of credit-builder loan is considered a secured loan and typically comes with a lower interest rate than an unsecured loan. Once you make all payments, the money in the savings account is released.

Another type of credit-builder loan is an unsecured credit-builder loan. These loans are often for small amounts, such as $500, but they usually come with higher interest rates due to their unsecured nature. You'll receive the loan proceeds upfront and will make payments just like with any other loan. In some cases, the lender may refund any interest you paid if you make all of your payments on time.

If you have savings that you can put up for collateral, you can take out a secured credit-builder loan. The main difference between a traditional credit-builder loan and a secured one is that you will receive the loan proceeds when you take out a secured credit-builder loan. In this case, you'll allow the loan to be secured by your savings account balance that you already had. The lender gives you the loan proceeds, and you make payments on the loan. Because the loan is secured, you'll usually receive a lower interest rate.

Is Getting a Credit-Builder Loan a Good Idea?

Getting a credit-builder loan can be a good idea if you have no credit score or poor credit. As long as you make all of your payments on time, a credit-builder loan should help you obtain a score or improve your credit, which should make getting future loans easier. Traditional credit-builder loans even help you save money, thanks to the way they work.

However, credit-builder loans aren't all good. Because you have no credit at all or a poor credit score, you may have to pay application fees, administrative fees and interest that may not be refunded even if you make all of your payments on time. You're essentially paying interest only with the hope of a better credit score after making loan payments. In the unfortunate event you do have to make a late payment, it will likely be reported to the credit bureaus and could damage your credit score.

If you're in a position where you're ready to build your credit and can access enough money for a security deposit, you may want to consider a secured credit card as an alternative. With a secured credit card, you'll put down a deposit and have access to a credit line that you can use to build your credit. If you pay off your balance in full each month before the grace period, you won't have to pay interest, either.

Where Can You Get a Credit-Builder Loan?

Finding a credit-builder loan can be a bit tougher than traditional types of loans because not all banks and credit unions offer them. However, you should still check with your local credit union or bank as well as their competitors to determine your options. Similarly, some online lenders may also offer credit-builder loans. After you research your options, compare the best offers to find which credit-builder loan works best for your particular situation. To get you started, here are a couple of credit-builder loan options you may want to consider.

Self Lender offers credit-builder loans in all 50 states. When you take out a loan, Self Lender puts the proceeds into a 12- to 24-month interest-bearing certificate of deposit (CD). Once you've paid off the loan, you'll get the money from the CD. Self Lender charges an account activation fee of $9 to $15 and offers monthly payments of $25 to $150, depending on how much you money you want to receive at the end of the loan. These monthly payments include interest.

  • The $25 monthly option requires 24 monthly payments and will give you $525 plus interest earned on the CD at the end of the loan.
  • The $48 monthly option requires 12 monthly payments and will give you $545 plus interest earned on the CD at the end of the loan.
  • The $89 monthly option requires 12 monthly payments and will give you $1,000 plus interest earned on the CD at the end of the loan.
  • The $150 monthly option requires 12 monthly payments and will give you $1,700 plus interest earned on the CD at the end of the loan.

1st Financial Federal Credit Union is a Missouri-based credit union that offers traditional credit-builder loans to its members. When the loan is paid off in full, you'll get access to the funds, and if you've made all of your payments on time, then you'll be refunded half of the interest you paid. Loans are offered for a 12-month term with loan amounts between $500 and $1,000 and a 12% interest rate.

Madison is a former Research Analyst at ValuePenguin who focused on student loans and personal loans. She graduated from the University of Rochester with a B.A. in Financial Economics with a double minor in Business and Psychology.