What are credit builder loans and how do they work?

Credit builder loans are just that – loans designed to help you build credit. They are unique loans in that you can usually qualify for them even if your credit is poor or you have no credit history. With that said, they do have their own limitations, and may not be right for everyone.

A credit builder loan is a loan with the primary goal of building your credit. The loan works more like a reverse loan, in that the lender does not give you money up front. Smaller financial institutions such as community banks and credit unions typically offer these loans.

The lender agrees to “loan” you a set amount of money, which it puts into a locked account. You then make payments as agreed upon in your loan terms, which typically lasts between 6 and 24 months. The lender then reports these payments to the credit bureaus. Paying the loan as agreed can help create your credit history or add positive marks to your credit history.

Once the loan is complete and paid in full, the lender gives you the loan amount. In this way, the loan works more like a savings account, as you do not have access to the money right away. In the end, you basically win twice. You have built your credit while also gaining access to a nice chunk of money.

Credit builder loans are great for people who are just starting out in the world of credit or who need a second chance to help repair their poor credit. Credit builder loans help face the frustrating double bind of the industry – namely that you need good credit to take out loans, but you need loans to build good credit.

The reasoning for this is understandable. Lenders are giving out money, which is risky. They want to protect themselves against this risk however possible, and use your credit behaviors as a sign of your risk. If you have poor credit or no credit, you are very risky in their eyes.

However, just because it makes sense does not mean it isn’t frustrating. Luckily, there are a few ways to build credit which lenders see as much less risky.

Credit builder loans virtually eliminate risk to the lender. By not giving you access to the funds immediately, the lender can always take the money back should you fail to fulfill the terms. So their investment is secured, and you still stand to benefit by both getting your “loan” and building your credit.

To apply for a credit builder loan, shop around with different small financial institutions, such as credit unions or community banks. Compare terms and rates of each before deciding which to use. Additionally, confirm the information they will report to credit bureaus, as that is the only way the loan will build your credit.

Next you’ll decide how much to borrow. The typical loan amount is somewhere between 300 and 1200 dollars.

Finally, apply for the loan, giving them your information. If you are eligible and the loan is approved, you will begin making payments until the loan is payed in full.

If you successfully complete a credit builder loan, it may have a significant impact on your credit score, especially if you are starting from zero.

With that said, the effect it has depends entirely on you. Lenders do report these payments to credit bureaus. So on-time payments will help your credit scores, and late payments will hurt them. This is especially important, as payments make up 35% of your credit score based on FICO scores.

If you pay on time and in full, a credit builder loan may have a significant helpful impact on your credit score.

While credit builder loans can be very helpful for you, they do come at an additional cost. Be on the lookout for different rates associated with the loan, such as:

If you are new to credit or have a lower credit score due to past mistakes, credit builder loans may be the ideal way to help you get back on track.

With that said, be sure to shop around to find the best deals, and be aware of any additional fees or long terms which may lead to you paying more on the loan than necessary.

If you make loan payments on time and complete the loan as agreed upon, credit builder loans can be a great jump start to a better financial future.