What Is a Credit-Builder Loan and Who Is It Best For?

Building credit when you have bad credit or no credit can feel impossible, since most personal loan lenders want you to have at least fair credit before approving you for a loan or credit card. A credit-builder loan is a way around this. It enables you to establish credit even when you have none or need to improve your score.

Here's what you need to know before applying for one.

What is a credit-builder loan, and how does it work?

A credit-builder loan is a small-dollar loan (often up to $2,000) for borrowers who want to build or repair their credit. It's not like a traditional loan that pays you a lump sum to use for purchases or paying down debt. Instead, your loan funds go into an account that you typically can't access until you pay off the loan — although some lenders make funds available to you as you pay or hold only a portion of your loan funds as collateral. The lender reports each payment to at least one credit bureau to help you boost your score.

In most cases, lenders place credit-builder loan funds into a savings account, which could earn interest or dividends. However, some use a certificate of deposit (CD), which typically pays a higher interest rate and could potentially give you back more than your original loan amount. 

Rates and repayment

Like regular loans, credit builder loans charge interest and require monthly payments. But APRs are generally lower for credit-builder loans since they're secured by your loan funds — it's common to see APRs in the 4% to 6% range. APR (annual percentage rate) measures the cost of borrowing, accounting for both the interest rate and upfront lender fees. Rates on credit-builder loans are typically much lower than traditional personal loans, which have rates ranging from around 7% to 36% — borrowers with bad and fair credit often get approved for rates around or above 30% (if they get approved).

Credit-builder loans also have repayment terms, usually between one and two years, although some have five-year repayment terms. Your repayment term defines the length of time you have to make monthly payments on your loan. A longer term can reduce your monthly payment, but it also increases the interest you pay over time. 

According to Martin Lynch, president of The Financial Counseling Association of America, financial institutions offer a wide range of credit-builder loans with different features, APRs, and terms. “Because there are so many variations these days, consumers need to do plenty of homework so they can choose the credit builder loan that best suits their circumstances.”

How do credit-builder loans help you build credit?

A credit-builder loan gives you the opportunity to prove consistent, responsible borrowing behavior. 

• Improve payment history: Lenders report each payment you make to one, two, or all three credit bureaus to establish or improve your credit history. Payment history accounts for 35% of your FICO score. 
• Diversify credit mix: Because credit-builder loans count as installment loans, they can also diversify your credit mix, which makes up 10% of your FICO score. If your credit report only has revolving credit accounts, like credit cards or a personal line of credit, adding an installment account shows that you can manage different debt types. 

Still, it's important to have realistic expectations for a credit-builder loan. According to Addy Perales, consumer lending manager at Addition Financial Credit Union, borrower behavior has a strong impact on how helpful a credit-builder loan is. “Many factors go into building your credit, such as on-time payments, other debts being reported, and how they are managed as well,” she says. “It’s not an overnight process and will take some great effort on your part by keeping tabs on your credit history and score.”

During loan repayment, it's smart to keep tabs on your credit score to track your progress. Use Credible's free credit-monitoring tool to check your score regularly.

Who are credit-builder loans best for?

Several financial products exist for people with bad credit, but it can be more challenging to find products that help you establish credit. Credit-builder loans mostly target credit-invisible or thin-credit borrowers who want to start building a credit profile.

People who are credit-invisible

A credit-invisible borrower has no reported credit history. This might be the case if you're moving out on your own for the first time and haven't yet financed a vehicle or opened a credit card, for example. Another common scenario is primarily using cash or debit cards to buy things rather than relying on loans or credit cards. 

People with thin credit

If you have thin credit, you don't yet have enough reportable credit history to give you a credit score. To illustrate, this can happen if you opened a credit card but haven't used it, so there's not enough information on your usage to help generate a score.

Having little to no credit won't make it more difficult for you to get approved for a credit-builder loan. “The assumption is that the applicant either has no history or a spotty one, at best,” says Lynch. “Instead, the lender's focus is on the applicant's ability to make monthly payments.” For that reason, having strong proof of income and a solid employment history can improve your chances of approval.

Pros and cons of credit-builder loans

Compare these benefits and drawbacks with those of other potential options, such as secured credit cards and personal loans, to find the path that best supports your credit goals.

Where can I get a credit-builder loan?

Credit-builder loans are commonly available from the following types of financial institutions:

• Credit unions: Credit unions require membership to apply for credit-builder loans, but they're known for lower interest rates and more personalized service compared to banks and online lenders. “Credit unions will tend to have a conversation and help guide you to a product that best suits your needs,” says Perales, which could be beneficial if you're unsure whether a credit-builder loan is your best option.
• Community development financial institutions: CDFIs are approved banks, credit unions, and other institutions that offer financial services to underserved communities, especially low-income areas. Visit the CDFI Fund and search the database to find CDFIs in your area. 
• Community banks: Small banks, like community banks, are more likely to offer credit-builder loans than nationwide banks. Having an established relationship may improve your chances of approval.
• Online lenders: A few online lenders, such as CreditStrong and Self, offer credit-builder loans. If you're interested in an entirely online application and borrowing process, an online lender could meet your needs.

How to get a credit-builder loan in 7 steps

Check with your lender to learn more about its application process and timeline. Generally, these are the steps to apply for a credit-builder loan:

1. Decide what you can afford: Review your budget to decide how much you can reasonably afford to pay each month. Consider the costs of regular bills, other debts you have now or expect during the loan’s term, necessities, and a cushion for emergencies.
2. Research lenders: Find lenders offering credit builder loans and compare loan features. Does one lender offer lower APRs than another? Will one let you access the money in your account after each payment, or do you need to wait until you pay off the entire loan to get your funds? Also, check reviews from other borrowers on reputable sites like the Better Business Bureau or Trustpilot.
3. Gather application documents: Find out what documents you need to apply — lenders usually note this at the beginning of the application process. The most common documents include identification, like a driver's license or passport, and proof of income, such as pay stubs or your most recent tax return. 
4. Apply: Submit your application and all supporting documents. Make sure your contact information is correct so the lender can contact you promptly if they need additional information to process your application. 
5. Review terms: If approved, the lender will send you the terms and conditions of your new loan to review. Check that the loan amount, interest rate, and funding process are correct.
6. Begin repayment: Once the lender funds your loan, you'll receive notice of your first payment's due date. Pay on time every month to help boost your credit. 
7. Monitor your credit score: Check your credit score and report regularly using a free tool like Credible's credit-monitoring tool. You can also get a free copy of your credit report from AnnualCreditReport.com. If your lender claims to report to all three major credit bureaus monthly, you’ll see the account and balance updated on your report. 

What are other smart ways to build credit?

A credit-builder loan is a one-time product that can give your credit a solid boost. But to maintain or continue building credit, consider other options as well.

• Make on-time bill payments: Paying your bills on time is the best thing you can do for your credit, as payment history makes up the largest percentage of your credit score. Sign up for autopay for any loan, credit, card, or utility account that offers it to help prevent missed payments and costly late fees. 
• Pay down existing debt: Keeping balances low compared to your credit limits shows lenders you can borrow responsibly. If you can, add extra cash to your minimum payments to bring balances down faster and reduce interest charges. Over time, this can improve your score and your financial flexibility.
• Open a secured credit card: A secured credit card uses funds you provide to secure your credit line. Your credit line will likely be smaller than it would with a traditional credit card, but secured cards are much easier to qualify for. Use the card regularly and pay off your balance in full each month to build credit. Eventually, you may be able to upgrade from a secured to unsecured card and get your deposit returned.
• Get a retail card: Retail or store cards are typically accessible to people with bad credit or limited credit histories, although they can have high APRs. But if you want to build credit with a credit card, a retail card can be a good one to start with.
• Take out a personal loan: Consider applying for a personal loan instead of a credit-builder loan if you need money upfront. Just be aware that, if approved, you may have a higher interest rate.
• Become an authorized user: Many credit cards allow the cardholder to add an authorized user — the credit account is then reported on the authorized user’s credit report. For this strategy to work best, Lynch says the primary user's credit utilization rate should be under 30% and the account should be old — the older, the better — as that will help increase the average age of the authorized user's accounts, which is 15% of their score. 

Disclosure: Some lending partners that participate in Credible’s comparison marketplace offer loans to borrowers with scores as low as 550. Borrowers with low scores will have fewer lending options than borrowers with higher credit scores.