Last Updated on February 1, 2022 by pf team
A credit builder loan, also known as a good faith loan, can be a powerful tool for building or rebuilding your credit if it has a few dings.
Here’s what you’ll need to know about credit builder loans and how to decide which loan to choose.
What is a credit builder loan?
A credit builder loan can have different structures but typically a credit builder loan is a special type of installment loan that pays out the loan proceeds after you've paid off the loan.
The credit builder loan allows you to demonstrate your responsible use of credit by making on-time payments. Your payment history for the loan affects your credit score.
Why use a credit builder loan?
Choosing a credit builder loan can benefit you in several ways, depending on your individual situation. As an extra benefit, you’ll earn interest on your deposit while you’re paying back the loan.
A few examples of how you can use a credit builder loan might include:
- Establishing credit – If you don't have credit yet, you already know how difficult it can be to get started building your credit. People with no credit or those with a thin credit history, like new graduates, can benefit for a credit builder loan. New immigrants can also build a payment history with a credit builder loan. In some cases, a credit builder loan or a secured credit card may be the only borrowing options available to borrowers with no credit or thin credit.
- Improve credit – Credit builder loans can also be useful for improving your credit. Higher credit scores benefit consumers in many ways ranging from lower interest rates for borrowing to other common expenses, like insurance rates or qualifying for apartment leases. A credit builder loan can help build your credit score without risking large amounts of new debt.
- Rebuild credit – Sometimes, life changes force a soft-reset. Bankruptcy, divorce, foreclosure, or other unfortunate circumstances can damage your credit and often can’t easily be prevented. Getting new credit after a life event damages your credit score can be difficult. Many borrowers may also be reluctant to take on new debt in the short-term. A credit builder loan offers a low-risk way to begin rebuilding your credit and turn the page on the financial challenges of the past. Because the loan amount for a credit builder loan is usually small, monthly payments can be easily managed with good budgeting habits.
How does a credit builder loan help you build credit?
Your payment history can make up 35% of your credit score. Making monthly on-time payments on your credit builder loan can help repair or build this crucial area of your credit score.
For example, if your credit score suffered following a job loss or another life change, one of the most common reasons for scores to drop is due to late payments.
If your credit history shows some missed payments, a credit builder loan can help rebuild by showing a new pattern of on-time payments.
However, it's important to choose your credit builder loan carefully.
You’ll want to choose a lender that reports to all 3 credit bureaus so you can begin repairing or building your credit score with all the major credit bureaus.
How to get a credit builder loan?
Getting a credit builder loan is often easier than you might think. However, it's helpful to know your budget beforehand. You'll want to be sure you can make on-time payments easily.
- Find a credit builder loan. Your local bank or credit union can be a great source for a credit builder loan, although you'll also find some online options. Be sure to consider the APR before applying. A credit builder loan offers a powerful tool you can use to build or rebuild your credit, but there’s no need to overpay. Often, you can get a credit builder loan for less than 10% APR. Longer loan terms often have higher interest rates. Also, keep a close eye on loan fees.
- Gather the documents you need to apply for the loan. Like most types of loans, you’ll need some basic documents to demonstrate you can repay the loan. Expect to provide proof of income, your Social Security number, name and address, and your banking information. Lenders also require identification, such as a driver's license, and some lenders may need additional information regarding your other monthly payments.
- Decide how much you want to borrow. Most credit builder loans offer lower borrowing amounts, typically ranging between $300 to $1000. A smaller amount borrowed can reduce the amount due monthly. Be sure the amount you borrow gives you a monthly payment you can afford every month. One missed payment can undo all the work you’ve done to build your credit score.
- Apply for the loan. If you have all your paperwork ready, applying for your credit builder loan is usually an easy process. If you’re using a local bank or credit union, you may have the option of applying in person or online.
- The lender opens a savings account or CD account. If you're approved for your credit builder loan, the lender opens a savings account on your behalf and funds the account for the loan amount. Some lenders use a CD instead. However, in most cases, you won't have access to the funds until you've made all the payments on the loan.
- Make your monthly payments. Lenders base the monthly payment for your credit builder loan on the amount you borrow, the interest rate, and the term of the loan. Higher loan amounts usually translate to higher monthly payments. Shorter loan terms also typically mean your monthly payment is higher.
- Check your credit score regularly. You can get a free copy of your Credit report once each year through AnnualCreditReport.com. However, if you need to check your score more often, you can buy a score from myfico.com or another trusted provider. The Consumer Financial Protection Bureau (CFPB) advises that you do not need to purchase additional services with your credit score. Some lenders offer free updates when your credit score changes.
- Finish paying the loan and collect your funds plus the interest. At the end of your loan term – usually 6 to 24 months, if you've made all the payments, you can withdraw the loan amount. In most cases, you're also entitled to interest on the borrowed amount. It won’t be much, but it’s yours. Some lenders may refund part of the interest you’ve paid as well.
Where to get a credit builder loan?
Traditionally, local banks and credit unions have been the primary source for credit builder loans, but online lenders and other options are now available as well.
Many larger banks don’t offer credit builder loans, but you can often find a credit builder loan through smaller community banks.
Call your local bank to inquire about a credit builder loan. If you have more than one community bank serving your area, be sure to compare.
Your local credit union can also be a good place to start your search. You can find a nearby credit union by using asmarterchoice.org.
Unlike banks, which are often owned by investors, credit unions are owned by the credit union members. This structure can translate to lower fees, lower rates, and other benefits.
In many cases, you can become eligible for membership just based on where you live, where you work, or where you worship.
Established by Congress in 1994 as part of an economic revitalization act, the CDFI Fund supports financial institutions and community development organizations.
The CDFI Fund doesn't offer credit builder loans directly. Instead, the fund helps to capitalize qualified organizations and financial institutions, which can then lend to the community.
Perhaps the most convenient option for a credit builder loan, online lenders like Self allow you to get a credit builder loan without leaving your home. In fact, with Self, you can even use your smartphone.
The lender offers mobile apps for iOS and Android. Self ticks all the boxes for a large segment of people who need to build or rebuild their credit.
Self works by funding your loan to a 12-month CD account. The lender also reports your payments to all 3 credit bureaus. After you’ve completed your loan term of 12 months, your funded CD unlocks.
You’ve built a solid credit history and earned a bit of interest as well. Not bad. Self also sends alerts when your credit score changes, a welcome extra that saves the added expense of buying credit reports.
As another option, you can also consider non-profit organizations that offer lending. In particular, you’ll want to investigate lending circles.
While informal versions of lending circles have been around for a long time in other countries, they began making a splash in the US in recent years.
With a lending circle, you become part of a group in which each member makes a set monthly payment. Members of the lending circle then take turns in receiving the loan proceeds.
For example, in a lending circle of 12 people, a different person would get the payout each month and everyone would get their money back after a year.
Lending circles sponsored by non-profits typically don’t charge interest but still offer the benefit of reporting your payments to the credit bureaus.
Be sure to check out California-based Mission Asset Fund, one of the best known lending circles.
What are the costs of a credit builder loan?
Credit builder loans usually aren’t free. Most loans charge interest. In addition, some loans charge an application fee and late fees are a potential expense if you can’t make a payment on time.
- APR. The annual percentage rate (APR) refers to the interest rate but also includes other costs of borrowing. When comparing loans, try to use the APR rather than the interest rate to make a fair comparison. Many loans charge over 10% interest. However, some loans refund part of your interest payments if you make all your payments on time.
- Application fee. Many credit builder loans also charge an application fee or administrative fee. For example, Self charges an administrative fee of $9.
- Late fee charges. If you make a late payment, expect a late fee with most credit builder loans. For example, you might pay 5% of the scheduled payment amount as a late fee if your payment is late by 15 days or more. If your payment is more than 30 days late, expect a late payment to show on your credit report.
Other options for building or rebuilding your credit
Credit builder loans aren’t the only way to build or rebuild your credit. Other methods may be a better fit, but each has its pros and cons.
Secured credit card
With a secured credit card, you make a deposit which then becomes your credit limit for the credit card.
As with all credit cards, you’ll make monthly payments and pay interest as well. Your payment history will be reported to the credit bureaus.
Be aware that a pre-paid card is not the same as a secured credit card. Pre-paid cards are useful in many ways, but they can’t help you build your credit.
You might find you have limited options with secured loans.
These loans use an asset as collateral, like a house or a car. If you have a low credit rating or are just starting out, it can be difficult to get approved or the loan might be costly.
It may make sense to build your credit with a credit builder loan before choosing a secured loan.
An unsecured loan can also be an option if you’re building your credit score. However, an unsecured loan may not be the best tool for all borrowers.
Typically, you’ll pay a higher interest rate if you have a lower credit score or you have thin credit. With some lenders, you may not qualify at all.
Interest rates for unsecured loans can range as high as 36%. On the plus side, most unsecured loans are reported to all 3 credit bureaus, so if you have a good payment history, you can use the loan to build your score.
Become an authorized user
Becoming an authorized user on someone else’s credit card can help build your credit in some cases.
However, this method may have more cons than pros. First, not all credit card companies report activity of authorized users to the credit bureaus.
But there’s a potential risk here as well. If the cardholder becomes delinquent on their balance, the delinquency may also affect your credit.
Find out how the lender reports the activity of authorized users before becoming one.
While you aren’t financially responsible for someone else’s debt, delinquent payments can still negatively affect your credit score.
Get a co-signer
If a low credit score or limited credit history prevents you from borrowing money, you can consider getting a co-signer for your loan.
When you use a co-signer, you're using that person’s good credit history to help you get approved.
However, the co-signer also accepts financial responsibility for the loan.
Late payments will affect your co-signer's credit score and your co-signer is equally responsible for the debt if you can't make payments.
Consider your other options carefully before choosing to use a co-signer.
Before entering a credit builder loan agreement
Look before you leap, as the old saying goes. Before you sign up for a credit builder loan, carefully weigh the cost and loan terms.
Choosing the wrong loan can create more problems than it solves.
- To get the most benefit from your loan, make sure the lender reports to all 3 credit bureaus. With the number of options available, there’s no need to settle for a lender that only reports to 1 or 2 credit bureaus.
- Think about the loan repayment term. Loans with longer terms often have higher rates. However, shorter term loans can have higher monthly payments as well. Consider both the loan term and the monthly payment amount. Set yourself up for success from the start.
- Find out what happens to the interest you pay on your loan. Some lenders keep the interest. However, we found several credit unions that refund part of the interest if you make all your payments on time. This can cut the cost of borrowing in half in some cases.
- Make sure the funds are insured. Bank deposits are insured through the FDIC, while most credit union deposits are insured through the NCUA.
- Read the fine print. It’s important to understand the fees and loan conditions before starting the loan. For example, Self offers a way to end the loan early if you think you might not be able to keep up with payments. Other loans may not offer the Same flexibility, potentially setting off an avalanche of negative credit remarks if you can’t keep up with payments. Also, keep a close eye on fees. Some newer lending circle apps charge a monthly fee, which can add up quickly.
Credit builder loans can be a great tool for building new credit or boosting your score but it’s important to learn the pros and cons before applying for a loan.
If you have other installment loans, like an auto loan, the impact of a credit builder loan on your credit report may be limited.
Credit builder loans are probably a better fit for people just starting to build credit or those who have some dings in their credit score.
If your credit is average or above and you already have installment loans, you may see a greater benefit by simply focusing on making on-time payments rather than taking on a new monthly commitment.