What is a Credit-Builder Loan and How Does it Work?

What Is A Credit Builder Loan
GUIDE
Erica Sandberg
By: Erica Sandberg
Posted: October 22, 2020
Our popular “How-To” series is for those who seek to improve their subprime credit rating. Our articles follow strict editorial guidelines.

A credit-builder loan is a unique financial product designed to help people easily and affordably add positive information to a credit report.

If you want to show the world what a great credit risk you really are but have a limited or damaged credit history, consider a credit-builder loan to help prove your creditworthiness over time.

A Credit-Builder Loan Acts as a Savings Account that Helps You Build Credit with Monthly Deposits

Credit-builder loans are quite different from traditional loans. Instead of the borrowed sum going to you to purchase something or pay off existing debt, the money is routed directly into a special secured savings account or a certificate of deposit.

Because it is technically a loan, interest is added to the balance. You repay the lender in equal installments over a fixed period. Terms typically range from six to 24 months, and most loans range from a few hundred dollars to a couple of thousand dollars.

Logos of Three Main Credit Bureaus

Credit-builder loans report your account information to the bureaus to help you build credit history.

During the lifespan of the loan, the lender furnishes the three consumer credit agencies — Experian, Experian, and Equifax — with your account information and activity, which is added to your credit file. The date the loan was issued, the original loan balance, and your monthly payment pattern will all show up on your credit reports.

Because credit scores such as FICO® Score and VantageScore® input the data from credit reports into their mathematical models that are designed to predict credit risk, your history of responsible borrowing and repaying will work in your scoring favor. Both credit scoring companies rank payment history as the most important factor, so as long as you make every payment on time, you will be building your credit.

But wait, there’s more! When the loan term is up and you’ve repaid the balance in full, the money is yours, free and clear. Therefore, credit-builder loans also act as a savings vehicle. Some lenders even give you back a portion of or all the interest you paid for the loan.

Where to Get a Credit-Builder Loan

Since credit-builder loans exist so you can jump-start a credit history and create an attractive credit score, they don’t have credit requirements. However, lenders want to be confident that you’re capable of making the payments, now and for the duration of the loan.

That’s why you need to provide your income information when you complete the loan application, which will be the primary qualifying factor.

As long as you have the ability to manage the payments for a credit-builder loan, you can start looking for one. Several different lenders offer these products:

  • Credit unions. The most common credit-builder loan lenders are credit unions. If you’re not already a member at one of these nonprofit financial institutions, consider joining one. Use the National Credit Union Association’s Credit Union Locator to identify a nearby credit union that you are eligible to join (for example, it may require you to be in a certain location or work in a specific profession). Credit union membership is free, and all it requires is opening a deposit account, such as a checking or savings account. Just make sure the one you’re interested in joining offers credit-builder loans, since not every credit union does.
  • Community banks. Although the bigger banks rarely offer credit-builder loans, smaller community banks may have them as part of their product portfolio and are worth checking out. As with credit unions, their mission is to help individuals become and remain financially secure. To find a community bank near you, visit the Independent Community Bankers of America website and use their online community bank locator
  • Online banks. Yet another option is lenders that do not have a physical presence at all. Some banks that operate entirely online offer credit-builder accounts that are similar to credit-builder loans. Just a few are Self, Republic Bank, and Fig Loans. Most of these lenders charge a small, one-time administration or processing fee, whereas community banks and credit unions may not.

To make the process advantageous for you, choose the credit-builder loan that has the fewest associated fees. If the lender does not rescind the interest when you’ve completed the pay-off process, look for the credit-builder loan that has the lowest interest rate, so you don’t overpay for financing.

You may also want to work with a lender that lets you monitor your credit scoring progress, so review the website or ask a representative about that technology.

How to Manage a Credit-Builder Loan

Because the intention of a credit-builder loan is to create a credit history that will ultimately translate into a high credit score, it is important to treat these accounts carefully and appropriately.

  • Pay on time. This is the most critical aspect of any loan because your on-time payments will lay the foundation for your creditworthiness. To make the process easier for you, enroll in your bank’s automatic bill pay system so the money you are supposed to pay every month is deducted from your checking account and sent to the financial institution without you having to prompt the transaction. Many lenders charge a fee if you’re a few days late, and if you’re more than 30-days delinquent, the lender will report you as late on your credit report. That defeats the purpose of the credit-builder loan, so take pains to pay by the due date. If you think you may be short one month, contact the lender immediately and ask for assistance.
  • Stick it out to the end. Along the way, you may want to stop making the payments because you want to use the money you’re paying to the loan for something else, or because you simply can’t afford the payments. Try to push through to the end, though, so you can gain the full benefit of the credit-builder loan. A loan you pay on time for a few months won’t do much for your credit scores, but one that you pay on time for a year or more can do a lot.
  • Contact the lender if you run into trouble. If it’s simply not possible for you to maintain payments on the loan, contact the lender immediately to cancel it. When you close the credit-builder loan prematurely, the lender will disburse the amount of money you paid on the loan (after subtracting any non-refundable fees) to you.

Again, simply paying your loan on time every month is the best way to manage a credit-builder loan, and your credit score will eventually reap the benefits of your commitment. Not to mention you’ll have a nice sum of cash returned to you to reward your efforts as well.

Other Ways to Build a Credit History

Check your credit reports and credit scores regularly as you use the credit-builder loan to add attractive data to your credit reports. You can obtain your credit reports from each of the credit reporting agencies once a year for free on annualcreditreport.com.

Get your FICO Scores and VantageScores too from the company’s websites. Neither action will affect or harm your credit scores.

You should see that your steady credit-builder loan payments are helping your credit scores rise. Both FICO and VantageScore have scores that begin at 300 and top out at 850. Higher scores are predictive of lower credit risk, and you will want to aim for scores that are in the mid-700s and above.

FICO & VantageScore Ranges

To get there, you’ll need to use a variety of credit products over a long period of time while always maintaining a perfect payment history with any account that shows up on your credit reports. For revolving debt products such as credit cards, you will want to make sure that your rolled-over balance does not exceed 30% of the amount you can borrow.

Another way to add points to your credit scores is by listing your utility and cellphone bill payments to your credit report with Experian’s Boost program. There is no charge for the service, and you don’t have to qualify for a credit product or concern yourself about getting into debt.

If you use a third-party payment platform to pay your rent, you can have your rent payments listed on your credit report as well. Among many other services, RentTrack and Rental Kharma will furnish information of your payments to the credit reporting agencies for a fee.

Whichever way you do it, once you increase your credit scores to the point where you can qualify for excellent credit products — those with low interest rates and preferable terms — you can start to add those to the mix as well. Just be sure to handle all credit products the same way.

For loans, you just need to get your payments in by the due date. For credit cards, only charge the amount you can and will repay in full within the interest-free grace period. This way you can avoid getting into expensive and long-term debt, while also ensuring a perfect payment pattern.

What to Do with the Credit-Builder Savings

When your credit-builder loan winds to a close, you will have a tidy sum of cash available to you. Make the most of it!

For example, you may have up to $2,000 at your disposal. Instead of running out and blowing all of it on an unnecessary indulgence, consider keeping most as an emergency fund.

Unexpected expenses are a fact of life. One day you may need to turn to the funds you have in a savings account to cover the cost of something important, like critically needed home repairs or a plane ticket out of town to visit a sick relative.

The best strategy is to use a credit card to make the initial payment, then turn around and use the cash you have in your emergency savings account to pay off that debt. By doing so, you will not just remain debt-free, you’ll continue to build and maintain a positive credit rating. Even better, if your credit card comes with a rewards program where you rack up points or cash back, you’ll profit from the process.

Add to the savings account that you created with the credit-builder loan by making regular deposits until you have accumulated between three and six months’ worth of essential expenses. Review your budget to get an accurate figure.

So if you discover that your necessary costs (rent or mortgage, utilities, food, transportation, kids’ expenses, etc.) total $2,000 a month, having at least $6,000 tucked away in a savings account will give you valuable peace of mind. At that stage, you can dip into that account as needed, then quickly replenish the amount you’ve withdrawn. Any excess funds are for you to enjoy and invest!

As you can see, credit-builder loans are just one step in the rung of a tall ladder. The goal is to ascend to a high credit score while making sure that your overall financial life is safe and steady.