What is a credit builder loan and is right for me?

New to the credit game? If you have no credit or a limited credit history, a credit builder loan can be helpful for both building your credit score from the ground up and eventually creating savings for things like an emergency fund.

Credit builder loans are small, safe loans that will give you a way to build credit from scratch or if your score is low. So, if you’re having trouble getting a credit card or auto loan due to a lack of credit, a credit builder loan might be a good place to start.

Given that your score will play a vital role in your financial future, it’s important to start somewhere when building it. By making payments over time (and on time), you can build your payment history, which plays a big role in determining your credit score moving forward.

If you’re ready to get the ball rolling with building your credit, here’s why a credit builder loan can be a good route to take.

What a credit score?

Your credit score is a 3-digit composite of your financial history, specifically focused on your habits of borrowing and repaying money. To have a credit score, you must have opened accounts, borrowed money, and paid it back at some time in your life. Most people start with a low to average credit score and gradually increase it over time.

There are 3 primary consumer credit reporting companies in the United States—Experian, Equifax, and TransUnion. These companies collect and receive data on hundreds of millions of consumers, and they organize all this information to create and sell credit reports.

A credit-scoring model takes the information in a credit report and generates a number that represents the likelihood that an individual will default on their payments.

Even if it can feel that way, it’s important to remember that a credit score isn’t a comment on your character, but rather a simple math model. It can also be a narrower way to judge your ability to repay a loan, and lots of companies are trying alternative methods in turn. That being said, your credit score remains one of the most popular measuring sticks when it comes to rates on loans, credit cards, housing opportunities, and even insurance.

FICO and VantageScore are two of the largest credit-scoring agencies in the U.S., and each company has multiple credit-scoring models. When checking your credit (whether it’s you, a creditor, or a landlord), the score can vary depending on which credit-scoring model is being used and which credit report it’s based on.

Generally, credit scores range from 300 to 850, with a higher score indicating that you’re more likely to pay on time. That credit score is usually calculated based on five different things:.

• Payment history:

  This looks at whether or not you’re paying things on time and in full.

• Credit utilization:

  Financial institutions want to see that you’re not using the bulk of your credit. Generally, try to use less than 30% of your available credit. So, if you have a credit card with a limit of $10,000, try not to have a balance of over $3,000 at any given time.

• Credit history:

  The longer you’ve had credit, the more financial institutions feel like they can trust you with it.

• Credit mix:

  To see that you’re good at all-around money management, financial institutions like to see a mix of credit types that you have responsibly made payment for. That could mean having a couple of credit cards, a car loan, and a mortgage, for example.

• Limited new credit:

  If you open a bunch of new lines of credit in a short time, it can look like you’re strapped for cash or in financial distress. And that’s a red flag for financial institutions.

Some of these things—like your payment history and credit utilization—get weighed more heavily.

It’s important to keep in mind that credit-builder loans don’t require you to have good credit for approval, but rather they are a way for you to build credit if you’re just getting started.

How does a credit builder loan work?

When you take out a credit builder loan, you don’t get the money right away. Instead, the lender holds onto the money. These loans are usually small, as are the monthly payments and the loan term (how long the loan lasts).

Most credit builder loans come in increments of somewhere between a few hundred to a few thousand dollars. The loan term is usually between six months and a couple of years. The annual percentage rate (APR) and other fees also vary depending on the lender and loan.

Say, for example, you get a credit builder loan with a two-year loan term and monthly payments of $25. For two years, you pay the lender $25 a month.

If you keep making those payments, at the end of the two years, you get two things. First, the lender releases the loan money to you to use for what you need, such as creating a savings buffer for an emergency fund. Secondly, you can get a better credit score. By making payments on time over the course of your loan term, you can build your payment history which plays a large role in your credit score.

Where can I get a credit builder loan?

Credit-builder loans are generally available through credit unions and smaller banks.

To apply, you’ll need information about your income, bank account balances, and employment history ready to go, as the lender will factor all of these in when determining whether to approve you, as well as the amount and terms of the loan.

As with applying for any loan, it’s important to shop around and do a bit of research to ensure you’re getting the best option.

Is a credit builder loan right for me?

All told, credit builder loans can be ideal if you don’t have any or much credit to your name. It’s low-risk for the lender because they hold onto the money until you’ve paid it off. And, it gives you a manageable way to learn good credit habits.

However, if you already have quite a few credit lines and a bad credit score, a credit builder loan probably isn’t right for you.

The Consumer Financial Protection Bureau (CFPB) analyzed credit builder loans to find out if they work and found that for people with no credit score, these loans increased their likelihood of having a score by 24%¹.

For people with existing debt, the credit builder loan actually caused a decrease in their credit score. But, those who didn’t have existing debt before getting the credit builder loan saw their credit score increase by 60 points versus those with existing debt. Ultimately, skip this loan if you have bad credit or significant debt, but consider it as a good option if you have no credit.

Keep in mind that a credit builder loan isn’t going to give you amazing credit overnight. But, if you’re struggling to build credit or simply wondering where to start, it might be a good way to get the ball rolling when it comes to setting yourself up for a healthier financial future.