Credit-Builder Loans: Using Loans To Build Credit
Hanna Kielar5-minute read
UPDATED: June 13, 2023
Getting a loan approved can largely depend on your credit score. Lenders want to know they’re investing in a borrower with a history of paying their debts. So, if you’ve never taken out a loan, this can reflect poorly on your credit score.
The good news? If you lack a credit history, a credit-builder loan can help improve your score and qualify you for other loans.
Take a look as we break down what a credit-builder loan is, how it can improve your credit and when getting this type of loan makes sense.
What Is A Credit-Builder Loan?
Unlike with a traditional loan, you can’t immediately access your cash from a credit-builder loan. Instead, you’ll make fixed monthly payments to the lender over the course of the loan’s term, and only once the loan is paid off will you receive the amount you were approved for.
Since the loan isn’t actually accessible until it’s repaid, lenders are more likely to approve applicants with low or nonexistent credit. This can be an ideal way for borrowers to give their credit a boost while posing little to no risk for lenders.
How A Credit-Builder Loan Works
When you’re approved for a credit-builder loan, your lender will set the loan amount – typically $300 to $1,000 – aside in a locked savings account or certificate of deposit (CD). You’ll then make payments toward the loan in monthly installments – with interest – for the length of the loan term, usually 6 – 24 months.
Every payment you make should be reported by your lender to credit bureaus and subsequently appear on your credit report. Full and on-time payments can build a positive payment history on your report over time, thus improving your overall credit.
Once you make your last payment, your lender will unlock your funds and deliver them to you.
Using this type of loan to help build credit works as a kind of practice run for a borrower. You’re essentially proving to a lender – as well as credit bureaus – that you can handle debt and make your monthly payments on time.
How To Get A Credit-Builder Loan
You can find credit-builder loans at traditional banks and credit unions as well as some online lenders. Since credit-builder loans are meant to help people improve their credit, most lenders don’t have strict credit requirements, and some even forego credit checks. As with traditional loans, you may need to provide personal information like proof of income, employment status and bank statements.
Follow these steps to find yourself the right credit-building loan:
- Decide on a loan amount. As noted already, you can typically borrow anywhere from $300 to $1,000. Keep in mind that choosing a higher amount can cost you more in interest over time.
- Find and compare lenders. Finding the right lender may require some shopping around before you land on one offering the best interest rate and terms. Fees vary by lender, too.
- Submit an application. Once you’ve found a lender that suits your needs and will report your payments to credit bureaus, submit a full application with the correct documentation and wait to hear back.
- Make your monthly payments. If approved, you’ll begin making your monthly payments, plus interest, and start building credit. Make sure your payments are on time, or you could end up damaging any credit you already have.
- Watch your credit score. Check your credit report throughout your loan term and see how your score improves over time.
Should You Get A Credit-Builder Loan?
Credit-builder loans aren’t for everyone. A study from the Consumer Financial Protection Bureau (CFPB) found that the loans were most beneficial to borrowers with no credit history and no existing debt. If you already have outstanding debt, you’d be better off paying it down before taking on another loan.
Payment history makes up 35% of your FICO® Score. You can improve this factor of your score by showing the credit bureaus you can make on-time monthly payments with a credit-builder loan. Late payments, though, can seriously hurt your score, especially when you already have minimal credit to your name. Make sure you’re financially able to make your payments, or you could find yourself back at square one.
Keep in mind that a credit-builder loan will cost you more than just your monthly payments. You’ll also pay the annual percentage rate (APR) your lender charges on top of the loan, as well as a potential application or origination fee. Longer loan terms can cost you more in interest, too.
However, if you can keep up with your monthly payments for the duration of your loan term, you’ll likely see a great improvement in your credit score. Once the loan is fully paid off, you’ll receive the amount you borrowed in a lump sum, which you can then spend or put into savings.
Alternatives To Credit-Builder Loans
If for any reason a credit-builder loan doesn’t sound right for you, it’s not the only option for building or repairing credit. See if one or more of the following alternatives would suit your situation.
Apply For A Personal Loan
A personal loan can be used for large purchases, debt consolidation, home improvements and almost anything else within reason. With a personal loan being a more traditional type of loan, you’ll receive your loan in a lump sum ahead of starting your monthly payments.
Personal loan interest rates largely depend on your credit score, so having little or no credit history can seriously affect your ability to qualify for a good rate, if you qualify at all. It’s possible to get a personal loan with no credit history, but you may have to put up collateral, have a co-signer or come to an agreement with your bank or credit union. Failing to pay back your loan can lead to consequences such as permanently losing your collateral.
As with credit-builder loans, making on-time payments toward a personal loan can give your credit score a needed boost and affect your credit in other ways.
Get A Secured Credit Card
Most credit cards have certain credit requirements, but secured credit cards can be a little more flexible on that front. Signing up for a secured credit card requires you to pay an upfront deposit – typically $200 or more – from which the credit card company can withdraw if you miss a payment.
Many credit card companies report credit card holders’ activities to credit bureaus, so you could improve your credit by regularly making on-time payments toward your balance.
Become An Authorized User
You can also build or improve your credit by becoming an authorized user of a friend or family member’s credit card account. There’s no credit check involved, and you gain access to the primary cardholder’s credit line for purchases or other expenses.
The primary cardholder is responsible for paying down the balance, and if they make their payments on time, you both benefit credit-wise. Just make sure the card issuer reports authorized users to credit bureaus, or becoming an authorized user may not affect your score at all.
Final Thoughts: The Right Loan Can Help Build Your Credit
Credit-builder loans can help bring your credit score to a respectable number if you keep up with your payments. If you’re financially secure enough to make your payments and don’t have existing debt, this type of loan can make you creditworthy for future loans, such as a mortgage. You have other options for building or repairing credit as well, but they may require additional steps or costs to qualify.
If you’re interested in a personal loan, you can start the application process today with Rocket Loans℠.
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