- A credit-builder loan is intended to help borrowers improve their payment history — and by extension their credit score — by reporting regular, on-time payments to major credit bureaus.
- Benefits of credit-builder loans include flexible acceptance criteria, the chance to improve your credit and the ability to build savings.
- Potential downsides to credit-builder loans include a drop in your score if you don’t repay it on time, fees and no immediate access to money.
Your credit score is the primary determinant of the rates you will receive when securing financial products and services. If that number is lacking you might be stuck with high interest rates and expensive monthly payments.
One way to address this issue is through credit-builder loans. While these are designed specifically for borrowers aiming to drive up their scores, the approach does not come without risk. Consider the benefits and drawbacks ahead of applying for a credit-builder loan.
Benefits and risks of credit-builder loans
Benefits of credit-builder loans
- Flexible acceptance.
- Can improve your credit.
- Ability to build savings.
Risks of credit-builder loans
- Potential to drop credit score.
- Lenders can charge high fees.
- No immediate access to money.
Pros of credit-builder loans
A credit-builder loan is a way to show the major credit bureaus you can consistently make on-time payments. By doing so, you’ll have an easier time accessing other financial products in the future. Consider the primary benefits to using one of these types of loans.
Because the market for credit-builder loans is designed for those with low credit scores and little or no credit history, lenders have much more flexible requirements. Lenders will not require good credit but instead will request information on your income, employment history and balances for your savings and checking accounts.
Can improve your credit
Most notably, credit-builder loans can improve your credit score. As you pay each month those on-time payments are reported to credit bureaus. Payment history accounts for 35 percent of your score, and as that improves your credit score will follow.
Ability to build savings
Typically when you take out a loan you are borrowing money to pay for a significant expense — but in this case the lender holds onto the money then returns to you once you’ve paid it off, minus any fees. With restricted access until it is paid in full you can effectively build extra savings.
Cons of credit-builder loans
Although credit-builder loans can carry many upsides, there are still risks associated with taking out a financial product. Take a moment to consider the drawbacks to this option before heading into the application process.
Potential to drop credit score
As with adding any loan to your rolodex a credit-builder loan has the potential to lower your credit score if you miss payments. Missing payments on a credit-builder loan can dramatically decrease your score and potentially put you in a more challenging financial spot.
Lenders can charge high fees
Like interest rates, standard fees vary significantly across different lenders. Some offer zero fees while others enforce steep fees that can shift your expected monthly or overall cost by a significant amount. Common fees included prepayment penalties, application or administrative fees and processing fees.
No immediate access to money
Credit-builder loans tend to carry repayment terms of up to 24 months, and access to the loan is not granted until after payoff. These loans are not great for those that require fast access to cash, as you must fully repay the loan to get the money.
When not to get a credit-builder loan
The ideal candidate for a credit-builder loan is an individual who does not have any credit history at all. It can be hard to take out financial products without any history, and these will assist you in building that history. Those with existing debt, on the other hand, might not be as good of a candidate for a credit-builder loan.
A credit-builder loan is also not a viable option for borrowers who struggle with on-time payments, as this is an essential part of the equation to improve your credit. Instead consider other options like secured credit cards or self reporting.
Taking out a credit-builder loan can be a great option for someone who needs help getting started on their credit journey. It carries more flexible acceptance than traditional loan products and builds savings.
But these loans are not perfect for every borrower as they can damage your credit score if mismanaged, tend to have high fees and do not offer immediate access to funds. If your main priority is to improve your score and you feel confident in your ability to pay off the loan, a credit-builder loan can be step one to achieving excellent credit.