Personal Finance

9 min read

October 01, 2021

What is a Credit-Builder Loan?

If you’re new to credit or trying to improve your score, a credit-builder loan might be just the ticket. Follow this detailed guide to decide if it is right for you.

As lending involves risks, lenders understandably prefer to provide loans to people with a good credit score. This makes it difficult for credit newbies to prove they can repay the loan on time and obtain typical forms of credit, like credit cards, personal loans, and so on.

Fortunately, there are ways lenders can provide you with credit without considering your credit history — one of these options is the credit-builder loan.

Here’s everything you need to know about credit-builder loans.

What is a Credit-Builder Loan? 

A credit-builder loan is specifically designed to help borrowers improve their credit score. Unlike traditional loans, you don’t get access to the money until you have paid off the loan completely. 

These loans do not require good credit for approval. However, just like other loans, you need to show you have enough income to repay the loan on time. Plus, you need to pay the interest throughout the loan term itself, making credit-builder loans one of the more expensive ways to build credit.

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How Does a Credit-Builder Loan Work? 

After your credit-builder loan application is approved, here’s what you can expect: 

  • The agreed-upon loan amount is deposited in the savings account set up by the lender. You can’t access the money until you’ve repaid the entire loan amount. This allows you to build both your savings and credit at the same time. 
  • You’ll make monthly payments towards the loan along with interest, usually for a period of six to 24 months. The interest rates vary depending on the lender, size of the loan, and the loan term. 
  • Every time you make a payment, the lender will report it to at least one credit bureau, and it also goes on your credit report. Recording such on-time payments builds a solid payment history, leading to a high credit score.
  • After you’ve made all your payments on time, the lender will release the funds from your account. 

In addition to this, as the lender doesn’t provide the loan amount at the beginning of the term, there is less risk of not receiving the money on time.

How to Get a Credit-Builder Loan

Follow these steps to obtain a credit-builder loan: 

Find the right lender: Not all financial institutions provide credit-builder loans. So, first identify lenders in your city who specialize in providing them. You can typically find credit-builder loans at community banks and local credit unions. In addition to this, numerous online lenders can help you increase your creditworthiness via credit-builder loans, such as Self Financial

Decide how much you want to borrow: While credit-builder loan limits are usually low, it’s important to consider how much amount you need to improve your credit score. The loan amount is typically between $300 to $1,000. Make sure you borrow what you can afford to repay. 

Shop around and compare different lenders: The terms of a credit-builder loan often vary by lender and the borrower’s income and creditworthiness. There might be significant differences between the interest charged, administrative costs, monthly instalments, and other fees. 

So, before finalizing the loan, check the lender’s policies. Also, make sure the lender reports to all three credit bureaus, namely Equifax, Experian, and TransUnion

Apply for your loan: Once you select the lender, submit a loan application along with all the necessary documents. Provide your basic information, such as name and address. However, the requirements may vary by lender.

Once your loan is approved, make sure you know when your first payment is due. It’s crucial that you never delay your payments as it can cause your score to go down, especially when you don’t have much of a positive credit history to offset it.

Credit-Builder Loan: Documents Required

The documents required to apply for a credit-builder loan may differ from lender to lender. However, the basic ones are: 

  • ID proof, such as a driver’s license;
  • Employment information; 
  • Income tax returns;
  • Savings and checking account bank statements; 
  • Proof of income;
  • Proof of address;
  • Other loan balances; 
  • Reference letters from other creditors.  

Where to Find a Credit-Builder Loan

Credit-builder loans aren’t easily available as traditional loans. Here are some possible sources: 

Credit Unions and Community Banks 

Over 15% of credit unions provide credit-builder loans. If you already bank with a credit union or a community bank, contact them to see if they offer this type of loan. You can easily find local lenders online by searching for “your city or state + credit-builder loans”. 

Some credit unions typically have membership requirements that vary by lender, such as the company you work for or the county you live in. To join, you’ll have to pay a small fee or donate to a particular charity. 

Community Development Financial Institutions (CDFIs)

CDFIs are private financial institutions that specialize in providing financial assistance to lower-income groups. To find one near you, visit the Community Finance Network’s CDFI locator or ask your bank. 

Online Lenders 

A simple online search can show you lenders that specialize in helping borrowers increase their creditworthiness. Some examples include Republic Bank and USALLIANCE Financial

Lending Circles

This practice is commonly used among families and friends. A group of six to ten people, with no or poor credit score, come together to build credit through lending circles, which offer zero-interest loans. 

The group agrees to a certain monthly payment and loan balance (say, $1,000), and each member pays the same amount per month (say, $100) to a central fund. The decided loan amount goes to one member every month until everyone gets their chance. In the meantime, the monthly payments are reported to credit bureaus.

Alternatives to Credit-Builder Loans

A credit-builder loan is an excellent option to boost or build your credit score. However, if it doesn’t seem a right fit, consider these alternatives: 

Secured Credit Cards

Unlike traditional credit cards, secured credit cards require you to make an upfront deposit, ranging between $200 to $2,000, which becomes your credit limit. Make sure you use the card responsibly and make at least the minimum payment on time to boost your credit. 

Be an Authorized User 

Being an authorized user on a friend’s or a relative’s credit card allows you to make purchases and build credit. However, the primary cardholder is responsible for making on-time payments. 

Remember, you won’t be able to build credit if the card issuer doesn’t report authorized user activity to the credit bureaus. So, check how the issuer handles reporting the authorized users to credit bureaus. 

Bottom Line 

While credit-builder loans are a great way to help credit-challenged people boost their credit scores, it’s crucial to make all the payments in full and on time. Also, shop around to find the right lender and understand the loan terms properly to ensure your credit building efforts are successful.

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Aishwarya Aggarwal
Aishwarya Aggarwal is a content writer passionate about helping brands create value-packed content that connects and converts. When not writing, she finds solace in dabbling with the beauty of colors on a white canvas.

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