What Is a Credit-Builder Loan?

By Ashley Kilroy · March 28, 2024 · 7 minute read

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What Is a Credit-Builder Loan?

There’s a saying that you have to spend money to make money. But what if you can’t get the money you need for a significant purchase, such as a car or a house?

Accessing credit can be challenging for borrowers who haven’t established a credit history or have mismanaged debt in the past. One option to consider: credit-builder loans.

This financial product is designed to help people with limited or poor credit histories access a modest loan amount and increase their credit scores by repaying it over time. A credit-builder loan doesn’t require a credit score for borrowers to qualify. And it provides an opportunity to restore your credit through affordable loan payments.

Here’s a closer look at this type of loan.

How Does a Credit-Builder Loan Work?

Credit-building loans use monthly repayments to help credit-challenged borrowers build credit. In other words, it’s a personal loan to build credit. Here’s a breakdown of how they work.

First, the primary purpose of a credit-builder loan is for borrowers to demonstrate responsible borrowing behavior over time. As a result, this loan type doesn’t give the borrower a large sum to immediately use, as with a traditional loan.

Instead of providing an upfront lump sum to the borrower, a credit-builder loan requires the lender to deposit the loan amount in an interest-bearing account. The borrower can’t access the funds until they pay off the loan through monthly installments. These loans range from amounts of $300 to $1,000.

Remember, credit-builder loans usually have an interest rate and fees. Therefore, your monthly payment will incorporate the principal, loan origination fees, and interest. The lender might return some of the interest to you at the end of the loan, but every lender differs on the specifics. Therefore, it’s vital to carefully read the terms and conditions of the loan agreement to understand the loan’s total cost and the perks.

The credit-building loan term typically ranges from 6 months to 2 years. Once the loan matures and you’ve made all the required payments, you’ll receive the amount (minus any interest or fees per the loan terms) in the collateral account.

Lastly, building credit takes time, so patience and consistency are key. Improving your credit through this loan can open up opportunities for future loans, credit cards, and other financial products. However, only some financial institutions offer credit-builder loans, so you may need to shop around to find one.

💡 Quick Tip: Before choosing a personal loan, ask about the lender’s fees: origination, prepayment, late fees, etc. SoFi personal loans come with no-fee options, and no surprises.

How Can a Credit-Builder Loan Help You Build Credit?

When you take out a credit-building loan, you make monthly payments towards the total amount. Your lender reports your payments to the credit bureaus, contributing to a higher credit score.

The low borrowed amount (also called the principal) makes the payments small and manageable. This feature helps borrowers with limited resources successfully pay the loan. Late payments and failure to pay the loan will hurt your credit, so it’s crucial to pay on time and take on a loan with affordable payments.

How to Apply for a Credit-Builder Loan

Applying for a credit-builder loan involves gathering information and choosing the option that best fits your circumstances. Here are the steps you should take.

Check Your Credit Report

Before applying for a credit-builder loan, it’s a smart move to check your credit report. You can get a free copy of your credit report from each of the three major credit bureaus (Equifax, Experian, and TransUnion) once a year through AnnualCreditReport.com. Reviewing your report will help you understand your current credit situation and set goals.

Research Lenders

Not all financial institutions offer credit-builder loans, so you’ll need to research various banks, credit unions, and online lenders. It’s recommended to find a lender that reports to all three credit bureaus to ensure the loan gives you the maximum benefit.

Then, you can ask each lender for information about their credit-builder loan products. Carefully read and understand the terms and conditions of the available loans. Pay attention to details such as the interest rate, fees, monthly payment amount, length of the loan term, and how much accrued interest you’ll receive at the end.

Gather Necessary Documents and Apply

Different lenders have different application requirements, but generally, you will need to provide:

•   Personal identification (e.g., driver’s license, passport)

•   Social Security number

•   Proof of income or employment

•   Information about your current financial situation

•   Monthly housing payment amount

•   References

Remember, a conventional credit check might not be necessary to qualify. Instead, the lender can review your banking history. Positive banking activity such as a checking account with a consistent balance can help your application. On the other hand, a history of bounced checks and unpaid loans can hinder your application.

Make On-Time Payments

If the lender approves your application and sets up the credit-builder loan, you’ll start making monthly payments on the agreed-upon date. Doing so will allow you to build a positive credit history.

Repay the Loan in Full

If you repay the loan successfully, you’ll finish in a span between six months and two years, depending on the loan. After you make the final payment, you’ll receive the principal plus any applicable interest. In addition, your credit history will reflect the on-time payments you worked hard to make.

Credit-Builder Loan Requirements

There are no credit score requirements for credit-builder loans because the goal is for borrowers to improve substandard credit histories. That being said, lenders may charge fees to provide the loan and impose requirements regarding your banking habits.

With credit-builder loans, lenders prefer borrowers with a banking history that demonstrates healthy financial practices. For instance, writing checks that clear instead of bounce is helpful for your application. In addition, little debt and a positive bank account balance are favorable markers. Lenders usually use a borrower activity report from a company like ChexSystems to review this information.

Is a Credit-Builder Loan a Good Idea?

A credit-builder loan can be a good idea for individuals with limited or poor credit histories. It’s essentially a personal loan to build credit. For example, if you’re new to credit and have little or no credit history, a credit-builder loan can help you establish a positive credit history.

Similarly, if you’ve had past financial difficulties that have resulted in a lower credit score, a credit-builder loan can be a tool for gradually boosting your credit score.

However, existing high debt balances may disqualify you from a credit-builder loan. This type of loan may also be insufficient in these situations and exacerbate your current problems because it adds another monthly payment to the pile.

Remember, using a personal loan to build credit can take time, so it’s crucial to be patient and not expect immediate results. It may take several months or even longer to see significant improvements in your credit score with this loan type.

In addition, the payments will work against you if you’re late, so the loan is only beneficial if you can afford the extra monthly expense. Lastly, you can’t access the borrowed funds until you pay off the loan, meaning you won’t receive money for immediate expenses after applying. So, if you’re looking for an infusion of cash to shore up your bank account or consolidate debt, a different loan product is likely a better idea.

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The Takeaway

A credit-builder loan is an effective tool for individuals aiming to build their credit profile. By emphasizing responsible borrowing behavior over time, this type of loan differs from conventional loans, as the loan amount is securely held in an interest-bearing account until you pay it off through monthly installments.

This loan type can benefit new borrowers without a credit history. However, it may not be suitable if you have existing high debt balances or need immediate financial assistance. Ultimately, understanding your financial circumstances and goals will help determine whether a credit-builder loan is the right choice for you.

Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.

SoFi’s Personal Loan was named NerdWallet’s 2024 winner for Best Personal Loan overall.

Photo credit: iStock/Weekend Images Inc.

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