Credit Builder Loans: What are They and Do they Work?

Credit scores help raise (or lower) a lender’s confidence that when they loan you money, you’ll pay them back.

But, if you never borrowed money, how is the lender to know you’ll pay them back?

It’s a chicken-and-egg scenario. You can’t show that you’re reliable until you have a loan, but you can’t get a loan until you show that you’re reliable.

That is where credit builder loans come in.

What is a Credit Builder Loan?

These are really not “loans” so much as they are savings accounts that help you build a credit history. They are offered by credit unions, community banks and community development financial institutions (CDFI) to help young people get a credit score or older people repair one.

You take out a small installment loan backed by your savings account. You make monthly payments like you would on any other loan. Once you have paid the “loan” back, the money you paid out is yours and the lender reports your success to the credit agencies.

When that happens, you have planted the foundation for a credit score.

“Credit builder loans get your foot in the door,” explained Rod Griffin, the Director of Public Education at Experian, one of the three major credit reporting bureaus. “The intent and the purpose is to help someone establish a traditional credit history, so that they can break the cycle of predatory lending. So, they can get away from things like payday loans and title loans, the high interest, high fee, short term loan market place.”

The key element here is that credit builder loans are reported to the credit bureaus. At least, they should be. The credit bureaus use the on-time payments as the basis for establishing a credit score. That is the only reason you would want one. Otherwise, it would be a savings account that you pay interest instead of earn interest.

“Anytime you apply for credit, you should ask and verify that they report their information to the national credit reporting companies,” Griffin advised. “If those payments aren’t reported, it won’t help you build credit.”

Types of Credit Builder Loans

There are two types of credit builder loans: Pure credit builder loans and share secured loans.

Pure Credit Builder Loans

A pure credit builder loan is a tool to build a savings account, while building credit at the same time.  The lender puts the entire loan in a savings account where it is frozen until the borrower pays off the entire loan. There is no initial deposit, only monthly payments until you pay off the loan.

Then, the money is yours and can use it as the deposit on a secured credit card. It also goes on your credit report and counts toward a credit score.

This strategy could be useful as a way to build savings to make a down payment on a car. Adding to your credit history should improve your credit score over time, which could lead to a lower interest rate on a car loan.

Share Secured Loans

The share secured loan uses a savings account as collateral. The borrower deposits a sum of money into a savings account. The lender freezes the money, and as the borrower pays back the loan, equivalent shares of your savings account are unfrozen.

This type of loan could be used by someone to improve credit mix, one of the factors in computing a credit score. It would result in only a modest increase of maybe 10 points, but that might be the difference between a “good” credit rating and a “fair” credit rating, which might be the difference in a percentage point or two on the interest rate you’re charged.

Credit bureaus monitor revolving credit (credit cards) and installment credit (auto loans, mortgages and personal loans like a share secured loan). A share secured loan could help someone who only has credit cards on their credit history, but it may only be a slight uptick since these are typically small short-term loans.

Creditors will be more willing to lend you money now that you have demonstrated you can handle month-to-month payments. They benefit anyone that wants to initiate a credit history or someone with damaged credit that wants to repair their score.

Where to Get a Credit Builder Loan

Credit builder loans are typically offered by credit unions and some banks. According to Steven Rick at Credit Union National Association, approximately 15 percent of credit unions offer credit building loans. Call your local credit union to see if they offer this type of loan and whether or not you have to be a member to apply. If membership is required, consider moving your checking account to the credit union. Some nonprofit organizations, like credit counseling agencies, offer credit builder loans.

Qualifying for a Credit Builder Loan

Some credit builder loans are only available to specific groups considered economically vulnerable, such as domestic violence survivors, the disabled, minorities, or refugees. Check with your bank or credit union to find out if they offer a credit builder loan and what the application requirements are.

The Secured Credit Card

Traditionally, the best way to enter the world of credit or repair a credit score is through a secured credit card. These are credit cards backed by a deposit equal to your credit card limit. Credit builder loans are a step toward getting a secured credit card.

“Secured credit cards are a very common method for building credit for the first time,” Griffin said. “You can also be added as an authorized (credit card) user, become a joint account holder and have someone cosign for you.

“However, people don’t always qualify for a secured credit card. Perhaps they don’t have a banking relationship initially, or the funds to put in a savings account. A credit builder loan is a tool they could use to start that process.”

You’ll have a nice savings account at the end of your credit builder loan term, and you can take that next step. Either use the savings for a deposit on a secured credit card, or see if you qualify for a low-limit unsecured credit card.

Credit builder loans are a safe way to start your credit. Griffin says the best way to improve credit is to get your credit report and look to the risk factors. Those tell you what affected your score the most and what you need to work on to make the score better. It’s usually something very simple.

“There is no real silver bullet,” Griffin said. “It’s really common sense things like always making your payments on time, and on credit cards in particular, keeping that balance as low as possible. If you do those two things, your credit score is going to improve over time, and you’ll get the credit you need. It’s about patience, time and consistency.”

Do Credit Builder Loans Work?

Recent research into credit building loans show that they can be effective in helping credit-challenged people improve their credit scores. However, the research is mixed. Data show that people who already have several lines of unsecured credit are typically not helped by credit-building loans. People with few to no credit lines, however, show significant growth in their credit scores.