What is a credit-builder loan?

How do credit-builder loans work?

A credit-builder loan differs from a traditional loan: Instead of getting money upfront and paying it back over time, you make payments to a lender for the loan term, then receive the funds back, minus interest. Credit-builder loans are geared toward individuals with little to no credit history and those looking to rebuild their credit.

With a credit-builder loan, you make payments for six to 24 months, then receive what you paid, minus interest, as a lump sum.

When you open a credit-builder loan — typically at a credit union or community bank — the lender deposits funds into a savings account. You won’t have access to those funds until you complete the installment payments, which include principal and interest.

Loan amounts on credit-builder loans range from $300 to $1,000, and payment terms last from six to 24 months. As you make payments, the lender reports them to the credit bureaus, which helps build your credit.

Once you reach the end of the loan term and have made payments on time and in full, you receive the loan funds. (Some credit-builder loans make part of the principal available after each payment.) Some lenders give you back a portion of the interest you paid.

How to get a credit-builder loan

Credit-builder loans are offered by some credit unions and community banks. Some online lenders and fintech companies also provide these loans.

To qualify for a credit-builder loan, you’ll likely need to show proof of income, such as pay stubs or tax returns. You should be prepared to disclose information about your employer and your monthly expenses and debts. The lender may not require a credit check; instead, it might request your banking history. If you have a record of returned checks, for example, this could affect your approval.

Before you apply for a credit-builder loan, you should compare loan offers from different lenders. Consider the following:

• Interest rate
• Loan fees, including any application, origination and late fees
• Annual percentage rate (APR)
• The loan amount
• The length of the term
• Whether the lender returns any interest

Do credit-builder loans work?

A credit-builder loan can be an effective tool for establishing or improving credit. For new borrowers, the loan helps establish a new account, which can lay the foundation of your credit history. According to Experian, an account usually needs from three to six months of activity before it can be used to calculate a credit score. Credit-builder loans have terms from six to 24 months.

Research shows a credit-builder loan is more beneficial for someone without a credit score or existing debt.

For both borrowers who have no credit history and those who want to rebuild it, making on-time payments on a credit-builder loan has a positive effect on payment history, which makes up the biggest share (35%) of your FICO credit score.

In a recent study funded by the Consumer Financial Protection Bureau, researchers found that for a group of borrowers without existing debt, taking out a credit-builder loan increased their likelihood of having a credit score by 24%. (It notes that nearly all participants who had existing debt already had a credit score.)

Overall, the study says, those without a credit score or without existing debt may find a credit-builder loan “especially beneficial.”

Keep in mind that a credit-builder loan could end up hurting your credit if you fail to make minimum payments on time.

Bottom line: Are credit-builder loans good?

A credit-builder loan can be a good option to help establish a credit history. According to the CFPB, it seems to be most advantageous for borrowers without a credit score or existing debt. If you have existing debt and need to raise your score, it may make more sense to pay down loans first or choose a different strategy for fixing your credit.

If you do decide a credit-builder loan is right for you, make sure to compare offers from multiple lenders to find the most favorable terms.