Everything You Need to Know About Credit-Builder Loans

How Do Credit-Builder Loans Work?

According to the Consumer Financial Protection Bureau, credit-builder loans generally come in increments of $300 to $1,000. You'll make payments toward these loans over six to 24 months, and you won't have access to the money you've paid until that time frame is over. But the lender reports your timely payments to the three major credit bureaus (Experian, TransUnion and Equifax), and once your loan term is up, you'll have savings you didn't before, making a credit-builder loan doubly useful.

When choosing a loan amount, consider a small one with easily affordable monthly payments, especially if you're on a tight budget. Repaying the loan on time is the most important factor for your credit scores, not its size.

You'll pay interest on the loan, but the lender may return a portion of that interest—sometimes referred to as "dividends" by the lender—to you at the end of the loan term. When choosing a credit-builder loan, make sure you understand its interest rate, any fees you'll pay, and the lender's policy on whether you'll receive the interest that has accrued.

You may not need to undergo a traditional credit check to apply for a credit-builder loan. Instead of using your credit score as a baseline for approval, some lenders may use your banking history through the consumer reporting agency ChexSystems. In this case, activities like bounced checks could affect whether you're approved for a loan.

To get most credit-builder loans, you'll need to provide some or all of the following:

• Employment information
• Pretax monthly income (lenders may allow you to keep any alimony or child support you receive out of this total)
• Pay stubs as proof of income
• If self-employed, tax returns as proof of income
• Total housing payment
• Other loan balances
• Checking and savings account balances
• References

Where to Get a Credit-Builder Loan

You likely won't find a credit-builder loan at a large national financial institution, if that's where you do most of your banking. Instead, try these options:

• Credit unions: Many credit unions offer credit-builder loans; search your local institutions' websites to see your options. You'll need to become a member of the credit union to get a loan, and you'll qualify based on characteristics such as where you work or where you live. To join, you'll pay a small membership fee or donate to a partner charity.
• Community banks: These locally owned banks may also offer credit-builder loans, and have a similar focus on financial education as credit unions. Search for a community bank near you using the Independent Community Bankers of America's search tool.
• Online lenders: Self Financial offers online credit-builder accounts, which are similar to credit-builder loans in that borrowers make monthly payments toward a savings account. You'll pay a one-time fee of $9 to $15 to sign up, depending on the loan balance.
• Lending circles: Peer groups can help each other build credit using lending circles, which offer interest-free loans usually facilitated by a community organization. The group decides on a monthly payment and loan balance, and each member pays the same amount per month to a central fund. Every month, one member receives a loan in the agreed-upon balance. In the meantime, monthly payments are reported to the three credit bureaus. One way to look up lending circles in your area is by using the nonprofit Mission Asset Fund's database.

How Can a Credit-Builder Loan Help My Credit?

A credit-builder loan is a type of installment loan, which has fixed monthly payments. Paying off installment loans on time contributes to healthy credit scores. In fact, payment history across all your accounts—including credit cards, student loans, auto loans and credit-builder loans—makes up 35% of your FICO^® Score^☉ , the largest share.

Credit-builder loans help you build credit if you don't yet have any accounts, and they can help restore credit if you have negative marks, like missed payments, on your credit report. By making on-time payments, you'll show lenders you can be trusted to take on other lines of credit in the future. A good credit score—one that's 670 or higher, according to FICO's model—can get you access to rewards credit cards or loans at more favorable interest rates.

Other Options for Rebuilding Your Credit

Getting a credit-builder loan isn't the only way to give your credit profile a boost. You can also use one or more of these strategies to build credit:

• Opt for a secured credit card: Unlike a traditional credit card, a secured credit card requires you to make a deposit, generally $200 to $2,000, which becomes your credit limit. That protects the card issuer if you can't pay off the charges. You can use the secured card like a traditional card, charging small amounts and paying your full balance each month. Over time, if you use the card responsibly, the bank may be willing to convert it to a regular unsecured credit card account. Make sure the issuer reports your account activity to the credit bureaus so the card will, in fact, help you build credit.
• Ask a family member to add you as an authorized user: Authorized users on credit card accounts are not responsible for making payments, but they can still use the account. Payment history will appear on their credit reports. Not all creditors report authorized user accounts to the credit bureaus, though, so ask before being added.
• Apply for a secured personal loan: A secured loan is one backed by collateral, which the lender could take possession of if you don't repay the loan as agreed. While a secured personal loan can help you build credit, the prospect of losing the collateral you put up—such as your car—could make this a riskier option than, say, a secured credit card that requires a small cash deposit.
• Apply for an unsecured personal loan: Unsecured loans aren't backed by collateral, so they may have higher interest rates and be harder to get than secured personal loans. Lenders will look at your income, credit scores and other financial obligations that affect whether you can repay the loan. But like secured personal loans and other installment loans, making on-time payments can bolster your credit score.

The Bottom Line

Credit-builder loans could help improve your credit and savings momentum at once. Because they're often supplied by community banks and credit unions, they also give you the opportunity to bank locally, if that's important to you. If your credit report is thin, you might find a credit-builder loan could help you reach the next level of financial know-how.