There are a few ways to build credit from scratch. You can get a secured credit card, become an authorized user on another person’s credit card, take out an auto loan with a co-signer. Another option is not as widely known, but can get you off to a good start from the ground up. It’s called a credit builder loan.
Credit builder loans are loans taken out specifically for establishing credit and improving a score. Usually they’re provided by credit unions or banks. Some nonprofits may offer these loans as well.
These are unique loans because they’re not designed for you to access money (although they should help you develop a solid on-time payment history). They’re simply to boost your credit score.
Why get a credit builder loan?
Credit builder loans come in especially handy if:
You don’t have much of a credit history. When credit history’s a prerequisite for investments as basic as a living situation, a savings account, or even a job, getting credit is essential.
You prefer not to use (more) credit cards. Multiple cards can build credit, but they can be a burden—we’ve all heard horror stories of credit card debt, for instance.
You’re clearing a financial milestone. Buying a home is one. So is buying a car. Better credit means more attractive interest rates.
You’re starting over. Maybe you’re new to the US credit system, or rebuilding after a crisis. Certain unions and nonprofits offer loans to “target markets” such as refugees or domestic violence survivors.
Many loans require you to be in decent financial shape first. Credit unions don’t look for perfection, but like most lenders they look for stability. You may need to have held a job for a certain length of time, for instance, or have a checking account with no overdrafts.
How does a credit builder loan work?
These loans aren’t huge. Most are within the $500 to $1,000 range. They’re designed to be reasonable to pay back. Keep in mind that, with interest, you may end up paying nominally more than the original amount.
You make payments on the loan over time. A common scenario: monthly payments over a year or two. The lender puts the money in an interest-bearing savings account, and you get the money once the loan’s fully paid.
There are three main types of credit builder loans.
A “pure” credit builder loan
The bank fronts the money and puts it in a locked savings account, while you make payments. This option doesn’t require you to put down money up front. It’s more like a savings layaway plan.
A secured loan
You “secure” the loan using money you already have in savings. The interest rate will likely be lower. Since you can’t access the money till it’s paid back, this type of loan is also a good opportunity to establish savings.
An unsecured loan
With this option, you get cash up front to use for expenses. You then pay the money back at a predetermined rate. Interest rates may be slightly higher. If cash on hand is a priority, an unsecured loan may be your best bet—but you still need to be able to make payments. In that respect, it’s similar to a credit card.
After about six months, you’ll get a FICO score if you didn’t have one already. If you’re trying to build an existing score, you can see a jump of maybe 20 to 25 points over the loan’s life. It doesn’t sound like much, but it can make a difference.
For good results, though, you have to make timely payments. Not just on the loan, but on any other bills you have that are reported to credit bureaus.
Read more: Compare unsecured personal loans here
Who offers credit builder loans?
Around fifteen percent of credit unions offer this service. To see if you’re eligible to join a credit union, go to A Smarter Choice.
See if your bank has credit builder loan options. Or if you’re just opening a bank account, find a bank which provides this type of loan.
Nonprofits focused on economic development, or serving a specific population, may have credit builder loans as a financial empowerment tool for those they serve.
Consumer Action provides a directory of where to find credit builder loans in your state, including nonprofits, credit unions, and banks. This list isn’t all-inclusive, but it’s a good place to start.
Before you take out a loan
Learn the specifics. What’s the interest rate, and how much interest will you end up paying? Will you need to put up collateral, and how much? What are the monthly payment amounts? How long will you be making payments? Is there any flexibility?
Make sure your lender is reporting to the three major credit bureaus, which they should be. After all, improving credit is the whole point.
Take time to find the best option for you. Credit builder loans can be a great way to show lenders that you can pay down a small loan responsibly. The better credit that results opens doors for larger opportunities.