What is a credit-builder loan?

As the name suggests, a credit-builder loan is a type of loan offered by credit unions and small banks that enables you to build credit. With a credit-builder loan, you make fixed payments to the lender and then get access to the loan amount at the end of the loan term. That’s different from typical loans, which involve borrowing money up front and then repaying it over time.

Read on to learn more about how credit-builder loans work, how they can help build credit, and who could benefit from applying for one.

What you’ll learn:

• A credit-builder loan gives you an opportunity to show that you can make consistent, on-time payments. 

• Credit-builder loans could be beneficial if you have little to no credit history or if you’re looking to improve your credit scores.

• Banks, credit unions, online lenders and financial technology companies may offer credit-builder loans.

• While credit-builder loans could positively impact credit scores and may be easier to get approved for than a personal loan, they might also come with higher interest rates or fees.

A credit-builder loan works differently from a traditional loan. With a credit-builder loan, a lender deposits the loan amount into a certificate of deposit (CD) or savings account, which you can access only after repaying the loan. 

Here’s a look at how credit-builder loans work if you’re approved:

1. Your lender sets aside the money: Your lender will set up a savings account or CD with the loan amount—usually $300 to $1,000, according to the Consumer Financial Protection Bureau (CFPB). Depending on the account and the lender, the loan might earn interest.

2. You make monthly payments: You’ll make payments with interest on the loan in installments, usually over six to 24 months.

3. Your lender reports your payments to the credit bureaus: Your lender should report the details of your payments, including whether they’re on time, to at least one of the three major credit bureaus every month.

4. You get access to the money: If you’ve made all your payments on time by the end of the loan’s term, your lender will make the funds available to you.

Yes, depending on how you manage it, a credit-builder loan may positively or negatively impact your credit.

A credit-builder loan is a type of installment loan and, in most cases, lenders report payments made on the loan to the credit bureaus. So whether you’re building credit from scratch or rebuilding your credit, a credit-builder loan allows you to demonstrate that you can handle making consistent, on-time payments, which can help you create a positive payment history.

But if you miss payments, make late payments or pay less than the minimum amount due, a credit-builder loan could negatively impact your credit instead.

Here are some general steps to getting a credit-builder loan:

You may be able to find credit-builder loans at:

• Community banks

• Local credit unions

• Online lenders

• Financial technology companies that specialize in helping people build or rebuild their credit

Credit-builder loans may not be advertised, so you might need to inquire directly with banks or credit unions to find them.

When choosing a loan amount, understand what the monthly payments will be to ensure you’re not maxing out your budget. Credit-builder loans can range from $300 to $1,000 and are typically over a term of six to 24 months. Interest charged to the loan adds to the monthly payment, but certain loan providers might return some of the interest paid in the form of dividends at the end of the term.

Lenders might look at your banking history through a consumer reporting agency like ChexSystems. A credit-builder loan won’t typically require a credit check, so that can make it easier to qualify for than other types of loans.

When you apply, you’ll likely be asked to provide things like:

• Employment information 

• Proof of income, like pay stubs or tax returns

• Loan balances

• Photo ID

• Housing, loan and credit card payment information

• Checking and savings account balances

Once you know what the monthly payment will be, review the terms and fees associated with the loan. In addition to an up-front fee, you may also need to pay an application fee and a processing fee.

After providing any necessary information and reviewing the terms and fees, you can submit the application. The lender might request more details before you’re approved. While some lenders accept every applicant, others could have certain qualifying guidelines that must be met.

Like any form of credit, there are both pros and cons to credit-builder loans:

The pros of credit-builder loans include:

• Ease of qualification: Credit-builder loans are relatively easy to qualify for compared with other types of loans and credit. 

• Ability to improve credit scores: Credit-builder loans can help you build a positive credit history and improve your credit scores if you make at least the minimum payment on time each month.

The cons of credit-builder loans include:

• High interest rates and fees: Credit-builder loans may come with higher interest rates and fees compared with other loan types.

• No up-front access to funds: Unlike other types of loans, you don’t get access to the loan funds until all payments have been made by the end of the loan’s term.

• Could hurt your credit: Even though credit-builder loans are meant to help build credit, they can negatively impact your credit history and credit scores if payments are late or missed.

A credit-builder loan is just one option for building credit. Whether you have poor credit or no credit history, here are some other ways you might be able to help build or rebuild your credit:

If you’re approved for a secured credit card, you get access to a line of credit up front, possibly without an annual fee. But a secured card typically requires you to pay a refundable security deposit to open the account. 

For example, the Platinum Secured card from Capital One has no annual fee and can be accessed with a security deposit of $49, $99 or $200. View important rates and disclosures. And if you use your credit card responsibly, you can earn back your deposit as a statement credit. Otherwise, it’ll be refunded if you close your account and your balance is paid in full.

Depending on the lender, you may qualify for a personal loan even with poor or no credit. Unlike credit-builder loans, personal loans provide access to funds up front, which you repay over time.

But if you’re considering applying for a personal loan to build credit, the options might be limited. For example, if you only qualify for a secured loan, it will require collateral, which means that if you default on the loan, you’ll likely lose your collateral. 

Keep in mind, some personal loans, like payday loans, carry unique risks and are less likely to help you build credit.

Becoming an authorized user on the credit card account of someone you trust can help you develop responsible credit habits. First, verify whether a card issuer reports authorized users to credit bureaus.

Once you’re an authorized user, the card’s account history may be added to your credit reports, although the primary cardholder is responsible for making payments. If you and the primary cardholder use the card responsibly, it could help you build credit. But irresponsible use could hurt the credit of both the account holder and you.

You might have better approval odds if you have a trusted family member or friend who is creditworthy and willing to co-sign on a traditional loan with you. With a co-signer, you could get better terms too, like a higher loan amount or lower interest rates. And if the loan is reported to the credit bureaus, positive payment history could improve your scores.

Credit-builder loans can be a helpful option if you are credit invisible or want to raise your credit scores. If you have the income for regular on-time payments, a credit-builder loan may be an option worth exploring.

But be aware of interest rates and annual percentage rates (APRs), which can add costs to your loan.

A credit-builder loan can be an excellent tool for helping you build or rebuild your credit. But there are other credit-building options out there too. No matter which ones you consider, be sure to do your research so you can make an informed decision on the best credit-building choice for you.

If a credit card geared toward improving your credit seems like a good option for your needs, explore the potential benefits of cards for building credit from Capital One and consider getting pre-approved today.