How Credit Builder Loans Work

Written by Banks Editorial Team
5 min. read
Written by Banks Editorial Team
5 min. read

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Your credit score is one of your most important financial numbers. It may impact the car you drive, where you live, and your ability to get a loan. Typically, lenders assess your score before giving you a loan, and each lender may have minimum requirements. Some people may not have high enough scores to qualify for a mortgage or auto loan. Even if you have a qualifying credit score, barely making the mark could result in a higher interest rate. 

Borrowers often work on their credit scores before applying for a loan. That’s because a higher credit score could lead to lower interest rates and may help reduce your down payment. Credit builder loans can help to fortify borrowers’ credit and qualify for better financing.

MoneyLion Credit Builder Plus - Save & Build Credit
Access Credit Builder Loans through Finance, Mobile Banking, Cash Advance & Auto Investing MoneyLion App. Save Money and Build or Improve Your Credit.

What is a Credit Builder Loan?

A credit builder loan is designed to help improve your credit. Typically credit builder loans are between $500 to $1,000, but some lenders let you take out a little more. These loans usually have terms ranging from 6 to 24 months. A lengthier loan minimizes the monthly payments and makes the loan more manageable. A shorter loan increases your monthly payments, but you get out of debt sooner.

Each on-time loan payment can help strengthen your credit history since payment history is reported to the major credit bureaus. Payment history makes up 35% of your credit history, making debt repayment one of the best ways to improve your credit score.

Unlike most financing options, most borrowers do not get the credit builder loan’s proceeds right away. Instead, the loan’s principal may be held in a separate account. As a result, you can only access the loan’s principal after you fully pay off the loan. Some lenders may give you a portion of the loan’s balance, but they are the exception rather than the rule. 

Most credit builder lenders do not want to incur much risk since they usually get involved with borrowers who have low or no credit. This structure helps prevent borrowers from falling deeper into debt and minimizes the risk for financial institutions while giving consumers the opportunity to rebuild their credit. However, not every bank offers credit builder loans, and you may have to seek out online lenders for this path. 

What is the Difference Between a Credit Builder Loan and Other Loans?

Any loan can help improve your credit score. Payments get reported to the credit bureau regardless of whether you take out a credit builder loan, personal loan, or line of credit. However, most people don’t take out personal loans, lines of credit, or mortgages, thinking about improving their credit scores. Many of these consumers have already done the groundwork to improve their credit scores and preserve good credit.

Credit builder loans are primarily for people who want to build their credit, while people take out other loans for different purposes. People with no credit or bad credit need to prove to creditors that they can make on-time payments and keep up with monthly loan payments. People with good and excellent credit scores do not take out credit builder loans because they are happy with their scores and have other financial obligations that strengthen their credit scores over time.

A key distinction is that credit builder lenders don’t give you the money right away. You have to pay the loan first before receiving the principal. This setup helps reduce the lender’s risk and provides borrowers with a way to help build their credit. Other loans may have quicker turnarounds for the principal. You can receive the proceeds within a few days and use them right away. Some loans require collateral, for example, mortgages and auto loans. Credit builder lenders will typically not ask for any personal items as collateral but will keep the principal until you pay off the loan.

How Does a Credit Builder Loan Help Build Credit?

Any loan will improve your credit score if you pay it on time, but not everyone can qualify for a loan. High requirements from lenders combined with some setbacks can put your credit score out of range. A credit builder account makes it easier to get financing even if you have a bad credit score and want to fix it.

Lenders report your payment history to the major credit bureaus. On-time payments could improve your credit score over time and demonstrate effective debt management. Your credit score won’t suddenly skyrocket, but if you build up strong payment history over several months, you may see improvements. Building your credit requires a long-term focus, and a credit builder loan can help you on that journey.

If your credit has taken a hit in the past, a credit builder loan could be a great starting point for recovery. Most creditors offer these loans to people who had a rough break and want to improve their score before applying for a conventional loan. Credit reports get updated each month, and you can monitor your progress to see how close you are getting to your credit score goal.

MoneyLion Credit Builder Plus - Save & Build Credit
Access Credit Builder Loans through Finance, Mobile Banking, Cash Advance & Auto Investing MoneyLion App. Save Money and Build or Improve Your Credit.

Some Things To Consider When Getting a Credit Builder Loan

A credit builder loan can help rebuild your credit, but some loans become more trouble than they’re worth. Before working with a lender, you should look through several credit builder loan options. These factors will influence whether a credit builder loan is right for you.

Fees and Other Costs

You can expect to incur fees and other costs when taking out a loan. These initial fees aren’t expensive but will increase your total costs, and some lenders charge higher prices than others. You should also check late fees in case you can’t make payments. If you feel nervous about late fees, you should consider a smaller loan or wait until you have enough reserves. For example, credit builder lenders may let you take out a $500 loan and stretch it out to 24 months. With this plan, you could reduce your monthly payments, so the late fees are less likely to come up.

Minimum and Maximum Loan Size 

Typically, credit builder loans are set at up to $1,000 as the maximum size for a credit builder loan, but some stretch the loan to a higher amount. Some borrowers don’t have much money to spare and would prefer to pay as little as possible. They can opt for the minimum loan amount instead, but this number will vary for each lender. 

Selecting a smaller loan amount may help reduce your monthly payments and help you save more money. However, a larger loan amount can demonstrate your ability to handle more debt and raise your credit score faster. The decisive factor should be your ability to repay the loan. You should not risk getting a higher loan amount if you feel nervous about making payments. Missing payments will hurt your credit score and leave you worse off than when you took out the loan. Get a higher loan amount if you can make on-time payments, but if you feel nervous about those payments, it is better to make some progress than risk another setback.

Monthly Payments

The Credit Builder Loan will take up space in your monthly budget. You should consider how much you can afford to pay before taking out a loan. Borrowers could help reduce their monthly payments by selecting smaller loan amounts with longer durations and lower APRs. You should compare creditors to see which one offers the most attractive monthly payment plans for your objectives. Don’t start doing business with the first credit-building loan provider you find.

Annual Percentage Rate (APR)

APR can vary from each lender and loan type, so it is a good idea to research and compare rates You can compare rates across credit unions, online lenders, and other financial institutions. Most lenders will set double-digit APRs for credit builder loans since borrowers with lower credit usually apply for these loans. A high APR has less of a sting if you take out a smaller loan amount or use a shorter loan term.

Interest Charge Back

Despite their best efforts, some borrowers fall behind on credit builder loan payments. The lender usually cancels the loan and repays your previous loan payments. Unfortunately, the lender will charge interest and a penalty for this chargeback. Most borrowers should not take out a loan if they’re nervous about the interest chargeback, but it’s a scenario worth considering. You should review each credit builder loan to ensure you work with a creditor that has a reasonable interest chargeback policy.

Should You Get a Secured Credit Card Instead?

Credit builder loans work well for people seeking to repair their credit, but a secured credit card can be a great choice too. These cards have no credit score requirement, but you will have to put up a refundable security deposit, similar to a credit builder loan’s requirement. In addition, some of these cards have rewards programs, and you can use them for any purchase.

While a secured credit card gives you more flexibility and turns everyday payments into credit-building opportunities, they tend to have higher interest rates than credit-builder loans. You may also have more fees if you fall behind on payments and try to exceed your credit limit. However, if you pay off the balance on time each month, a secured credit card is a great option. Most credit card issuers even let you switch to an unsecured credit card within 6-18 months after responsibly using the secured card.

Credit builder loans and secured credit cards are meant to be temporary ways to improve your credit. Credit builder loan borrowers hope to graduate to traditional loans, while secured credit card holders hope to upgrade to an unsecured credit card in the future. Both of these resources can demonstrate your ability to manage more debt and get you a good credit score.

MoneyLion Credit Builder Plus - Save & Build Credit
Access Credit Builder Loans through Finance, Mobile Banking, Cash Advance & Auto Investing MoneyLion App. Save Money and Build or Improve Your Credit.

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