How Do Credit-Builder Loans Work?

How Do Credit-Builder Loans Work? article image.

It's a classic catch-22: You need good credit to take out a loan or qualify for a new credit card, but you need a credit card or loan to build good credit. If your credit is less than stellar, it can be difficult or even impossible to find a lender willing to work with you. What can you do? One option is to take out a credit-builder loan.

What Is a Credit-Builder Loan and How Does It Help Build Credit?

Credit-builder loans are typically for small amounts of $1,000 or less. These loan usually have a repayment term of six to 24 months, so it's a short-term loan borrowers primarily use to boost credit.

With credit-builder loans, money you borrow is set aside for you in a secured savings account or certificate of deposit (CD) while you pay off the loan. Once you make all of the monthly payments—with interest—then you receive the funds. While you make payments, the lender reports your payment activity to the three major credit bureaus (Experian, TransUnion and Equifax).

The idea is that you can show off your ability to make regular, on-time payments over a period of time. That's important because payment history typically accounts for 35% of your credit scores. In the end, you not only improve your credit history but also save money you might not have otherwise.

Once you increase your scores, you can start qualifying for other forms of credit, such as personal loans or credit cards, which can further improve your credit (provided you keep making payments on time).

Does Missing a Payment Impact My Credit?

While a credit-builder loan can be an excellent tool for improving your credit, missing payments on that loan can have the opposite effect. If you miss a payment on the loan or are even just a few days late, the lender may report that activity to the three major credit bureaus, which will cause your scores to drop. That's why you should only take out a loan if you're sure you can afford the payments.

What Happens After I Pay Off the Loan?

Once you make all of the required payments on your credit-builder loan, the lender will release the funds to you. In some cases, the lender will issue you the money along with some of the interest that you paid, minus the cost of fees. However, not all lenders have this policy, so it's a good idea to find out the interest rate, fees and policies on returning interest paid when you are shopping credit-builder lenders.

Usually, the money is wired directly to your checking or savings account as a lump sum. The money is then yours to use as you wish; you can boost your emergency fund, pay down debt or save it for a major purchase.

Is It Possible to Get Out of a Credit-Builder Loan Early?

While most lenders will allow you to pay off the credit-builder loan ahead of schedule, doing so defeats the purpose of taking out the loan in the first place. By repaying the loan early, you cut short the positive payment history, which is what you're trying to achieve to help build credit.

One thing to keep in mind is that there are different consequences for paying off a loan ahead of schedule if your money is kept in a certificate of deposit (CD). If you do pay off the loan early, you'll need to wait to close the CD and withdraw the money. And you'll have to pay a penalty. If you've taken out a credit-builder loan to improve your credit, it's best to complete payments per the loan term and not pay it off early.

Do Credit-Builder Loans Earn Interest?

With some credit-builder loan lenders, the lender places your funds in an interest-bearing savings account or CD while you make payments. When you finish making payments, the amount is released to you. While you can technically earn some interest on a credit-builder loan, the rate you earn in interest will be at a far lower rate than the interest you pay on the loan.

For example, you may have a loan held in a CD that earns 1.25% interest. But the interest rate you're paying on the loan could be as high as 15%. Any earnings that you would have made—and it's likely you won't earn more than a couple of dollars—will likely be eaten up by the interest rate and fees you pay on the loan.

What Fees Do Lenders Charge on Credit-Builder Loans?

Credit-builder loans can be helpful, but they can also be expensive. Some credit-builder loans have significant fees, including:

  • Administrative fees: These are usually paid before you can qualify for the loan. For loan provider Self Lender, for example, the administrative fee can be $9 to $15.
  • Annual percentage rate (APR): Credit-building loans charge interest and fees; the APR is the rate of interest they charge. APRs typically range from 6% to 16% on these loans and are dependent on your creditworthiness and the lender's rates.
  • Late fees: If you miss a payment, you may have to pay a fee on top of what you already owe—usually a percentage of that missed payment.

If used carefully, credit-builder loans can be a great first step toward establishing a strong credit history so you can qualify for other types of credit. However, it's important that you're aware of the fees associated with them, as they can be costly.

If you're looking for other options to boost your credit, consider applying for a secured credit card. If you pay off your statement balance in full each month, you'll avoid paying interest and still increase your credit score.