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How Do Credit Builder Loans Work?

Credit builder loans are designed to help you build your credit history. Here's how they work and what to consider to determine if one is right for you.

How Do Credit Builder Loans Work?

Building credit from scratch can feel like a Catch-22. With many lenders, it's challenging to get approved for credit if you don't have a credit history. At the same time, you can't establish a credit history without some form of credit.

One way to do this is through credit cards, but you may run into some limitations with most available credit card options.

Enter credit builder loans. These loans are specifically designed to help you build credit and nothing more. Here's what you need to know about credit builder loans and how to decide if one is right for you.

What Is a Credit Builder Loan?

A credit builder loan is a type of installment loan that you can use to build your credit history. The primary difference between a credit builder loan and a traditional installment loan, such as a personal loan, is that you don't receive the money upfront from a credit builder loan.

Instead, the lender holds onto the principal amount while you make monthly payments. Then once you've completed the payment term, you receive the full loan amount.

How Does a Credit Builder Loan Work?

When you first apply for the loan, the financial institution sets the loan amount in a separate account, such as a certificate of deposit or savings account. Then you start making monthly payments based on the terms of the loan.

In most cases, loan amounts range up to $1,000, but some lenders offer more. You can typically choose a payment plan that ranges from six months to several years—six months is the amount of time using credit that's required to calculate a FICO® Score if you have no credit history at all.

As you make your monthly payments with interest, the principal amount of the loan may also earn interest in the account where it's being kept. That said, the rate you're paying will likely be higher than the rate it's earning.

As you make your payments, the lender will report them to the three national credit bureaus, Experian, Equifax and TransUnion. That information can then be used to give you a FICO Score, which you can use to apply for other types of loans and credit cards.

Once you've paid off the loan, you'll receive the proceeds with any interest they've accumulated over the payment period.

In some cases, financial institutions may offer similar loans called savings secured or share secured loans. The difference is that these loans require you to lock up the amount of the loan in a savings account with the bank or credit union—which means you need to already have that cash in savings to get approved.

If you don't have any cash you can tie up for several months or years, you may be better off with a credit builder loan.

Where You Can Get a Credit Builder Loan

Banks, credit unions and online lenders offer credit builder loans, though it's not as common as other loan types. Run a quick internet search to find lenders that operate in your state and compare multiple options before you submit an application.

This is important because different lenders charge different interest rates and have other terms that can vary. Taking your time to shop around can save you money and make for a better borrowing experience.

Who Should Apply for a Credit Builder Loan?

Credit builder loans are specialized to help people with no credit history, limited credit history or poor credit history to establish a positive profile.

That said, if you already have other credit accounts, such as a credit card, an auto loan, a student loan or a mortgage, you may not need a credit builder loan. Instead, you can simply use the credit accounts you currently have to establish a positive credit history.

If you don't have any other type of credit, however, a credit builder loan can be a good way to achieve your goal of establishing your FICO® Score without the threat of credit card debt or going into debt to buy something you don't need.

Alternatives to Credit Builder Loans

If you're thinking about getting a credit builder loan, it's important to compare potential alternatives before you settle. Here are some options to keep in mind.

Credit Cards

One of the benefits of a credit card is that you can build credit without paying interest, as long as you pay your bill on time and in full every month. If you're a college student, you may be able to get approved for a student credit card.

If not, most of the options available are secured cards, which require an upfront deposit. But there are also some unsecured options available that don't require you to pay anything upfront.

The biggest drawback of getting a credit card is that it opens up the possibility of racking up high-interest debt. If you're concerned about overspending, it may be best to skip a credit card.

Student Loans

If you're a college student or a recent graduate, your student loans will be able to help you build your credit history once you start making your monthly payments. As with other forms of credit, your lender will report your monthly payments to the credit bureaus.

If you don't want to wait until you start making those payments, though, consider a credit builder loan, credit card or one of the other options.

Auto Loan

If you need to purchase a car, getting a loan on your own without a solid credit history can be difficult. But if you have a family member who has good credit and can co-sign the loan application, it can help you get approved, and you can start building your credit profile with your on-time payments.

Just keep in mind that it's best to avoid borrowing money to buy a car if you don't need it. The same goes for personal loans, which are best used for debt consolidation.

Also, if you do need a car, try to avoid borrowing more than you can afford to repay.

The Bottom Line

Credit builder loans can be a good way to establish your credit history for the first time or to start the process of rebuilding your credit after a bankruptcy, foreclosure or other negative credit events.

Before you apply for one, though, look at your current situation to determine if you actually need one. If you have other credit accounts that you're paying on time, that may be enough to increase your credit score.

Even if you don't have other types of credit, take your time to consider some alternatives to credit builder loans to see if one might be a better fit for you.

Finally, if you've decided that a credit builder loan is right for you, take some time to search lenders and compare what they have to offer, so you can ensure that you get the best deal that you qualify for.

Ben Luthi

Ben Luthi has been writing about money and travel for seven years. He specializes in consumer credit and has written for several major publications and industry leaders, including U.S. News and World Report, Fox Business, Wirecutter, Experian, and Credit Karma.