What Is a Credit Builder Loan?

February 01, 2023

A credit builder loan is a tool to help people build their credit for the first time or repair their damaged credit scores. With a traditional loan, you receive a lump sum of money that you pay back over time. With this loan, you pay the bank or credit union over some time and then receive that money back as a lump sum. It’s almost like a reverse loan.

So, let’s learn more about credit builder loans below and who can benefit from this option.

What Is the Purpose?

This loan builds up your credit score by proving that you can make consistent payments over time. Payment history is one of the most significant factors related to credit scores. So, if you miss mortgage or credit card payments, your credit score can drop.

A low credit score tells banks that you are a high-risk borrower. They might deny loan applications or charge higher interest rates because of a low credit score. This means you pay more to borrow money.

By making consistent payments on your credit builder loan, you can increase your credit score and qualify for more loans and loans with lower interest rates.

How Does It Work?

When you take out a credit builder loan, your bank will set aside the designated amount you intend to pay in a specific account. You will make flat monthly payments for the duration of the loan (usually between six to 24 months). During this time, the bank will report your on-time deposits to the major credit bureaus, which builds your credit history. Once you complete your payments, your lender will give you access to the money.

For example, if you take out a $2,000 loan, you would make payments of $166 on the principal balance over 12 months. Your monthly payment would likely be higher than $166 based on the interest charged on the loan.

What Are the Risks and Rewards?

Every financial decision comes with its risks and rewards. The main risk with taking out a credit builder loan is missing payments. Your credit might worsen if you can’t make your monthly payments.

However, if you can make these monthly payments, you could build your credit while saving money. For example, you could take your improved credit score, and lump sum returned to you from the credit builder loan to put a down payment on a house or car with a more reasonable interest rate than you would have been approved for before your loan.