How to use a credit-builder loan to establish credit

What is a credit-builder loan?

Credit-builder loans are intended for consumers who want to improve their credit but don’t qualify for traditional credit products.

With credit-builder loans, you don't actually borrow any money. Instead, credit-builder loans let borrowers make payments to a savings account or certificate of deposit (CD) for the duration of the loan term. At the end of the term, you get back the amount you paid in, less any interest charges and fees.

Since these loans can't be used to make purchases, you may be wondering what their appeal is. According to Monique White, head of community at fintech startup Self, the entire reason to get a credit-builder loan is to build up a history of payments that can be shown on your credit report. Payment history is the most important factor used to determine both FICO and VantageScore credit scores.

As you compare credit-builder loan options, you'll quickly notice that these loans are offered in relatively small amounts and typically have terms that only last up to two years. Interest is charged on credit-builder loans, and some lenders may also charge an administration fee.

As an example, a 24-month credit-builder loan from Self with a $35 monthly payment would result in total payments of $840. The borrower would get $724 back once the loan term ends, meaning they paid $116 in interest. Self also charges a $9 one-time fee to administer the loan. These numbers are accurate as of the time of publishing.

Credit-builder loans vs. personal loans

Credit-builder loans don’t actually lend you money, unlike personal loans, which provide borrowers with an upfront lump sum of cash to be paid off over a specified timeline (usually two to seven years). Since both types of loans help you build credit, you may wonder why anyone would choose a credit-builder loan rather than a personal loan.

The key here is that credit-builder loans are available to people with low credit scores or no credit history, whereas many personal loans have stricter approval criteria.

Personal loans for borrowers with bad credit do exist, but they tend to charge very high interest rates due to the increased level of risk their lenders take on. For example, it's not uncommon to find personal loans for bad credit with annual percentage rates (APRs) of around 36%, whereas APRs for credit-builder loans typically top out at about 16%.

White also points out that, at the end of a credit-builder loan's term, you unlock the payments you made and get the savings you built back — minus interest and fees. In that sense, a credit-builder loan is like a forced savings account, differentiating it even more from a personal loan, which gives you money upfront that you must pay back.

» MORE: How do loans work?

How credit-builder loans can help your credit

Payment history makes up a whopping 35% of FICO scores and 41% of scores that use the VantageScore 4.0 model. With that in mind, it's easy to see how a credit-builder loan can be advantageous. You make payments that are reported to credit bureaus, which can improve your credit. You're also saving money along the way, which you'll get to access at the end of your loan term (minus loan costs).

Credit-builder loans are also easy to get approved for, and their monthly payments can be as low as $25 or so. This means it could be possible to fit a credit-builder loan into your budget even when cash is tight.

How to get a credit-builder loan

The best credit-builder loans are offered by Credit Karma Money, Digital Federal Credit Union and Self. These lenders vary slightly in the terms and conditions of their credit-builder products, but they all essentially work the same way.

Before you choose a credit-builder loan, you should compare fees and interest charges as well as monthly payment options. Ideally, you'll choose a loan with a low interest rate, minimal fees and a monthly payment amount that makes sense for your budget.

Once you compare credit-builder loan options, you can open an account by applying online and sharing your full name, address, income details and Social Security number with the lender you’ve chosen. After your account is set up, you'll begin making monthly payments toward the loan according to the plan you agreed to.

Other ways to build your credit

Credit-builder loans can help you build credit when you don’t qualify for traditional credit products. But there are some alternatives to consider, including:

• Secured credit cards: With a secured credit card, you put down a cash deposit as collateral, which usually becomes your card's credit limit. You can use a secured credit card to pay bills or make purchases, and your credit usage will be reported to credit bureaus. Some secured credit cards even let you earn rewards on your spending.
• Becoming an authorized user: You can become an authorized user on another person's credit card if they'll allow it. This move can help you build good credit habits while potentially adding positive payment history to your credit reports.
• Credit-building apps: Apps like Experian Boost can help you build credit from payments like utilities and rent, which are usually unlikely to improve your credit score.
• Rent reporting companies: Since rent is often the biggest payment people make each month, White says it makes sense to use rent payments to your advantage. Several companies, like Rental Kharma and RentReporters, report your rent payments to credit bureaus in exchange for fees.

Financial expert Lynnette Khalfani-Cox says people who want to establish or reestablish credit after past mistakes should definitely consider these alternatives — especially secured credit cards. That's because secured credit cards don't charge any interest if you don't carry a balance. And many come with no annual fee, whereas credit-builder loans cost money no matter how you use them.

Besides being potentially less costly, secured credit cards have a number of other advantages over credit-builder loans, Khalfani-Cox said. For example, secured cards give you control over your credit utilization, meaning you can purposely keep your credit usage low to boost your credit score. Your credit utilization ratio makes up 30% of your FICO score.

Secured credit cards also let you make purchases, and many offer rewards for your spending, along with other perks. Furthermore, secured credit cards can help you move on to the next phase of your financial life sooner.

"Responsible use of a secured credit card can lead to an upgrade to an unsecured credit card with the same issuer, often with better terms and higher credit limits," said Khalfani-Cox. "This can further improve your credit score and provide more financial flexibility."

» MORE: Secured vs. unsecured loans

Bottom line

Credit-builder loans may be somewhat imperfect, but they do offer the chance to build credit when other lenders won't approve you for traditional credit products. Credit-builder loans also come without some of the risks of secured credit cards, including the risk of using a secured card to make purchases you can’t afford.

If you need to build credit and can't seem to find another way, a credit-builder loan may be exactly what you need. By making on-time payments and sticking with the plan, you’ll build good credit you can rely on in the future.