Establishing credit isn't always simple, especially since many lenders require a credit history before opening an account. This makes it difficult for credit seekers to obtain traditional forms of credit, such as credit cards, but there are some alternatives.

A credit builder loan is one option that does not typically necessitate a credit history. This loan is specifically designed to help you build credit as you make loan payments. However, credit builder loans, like other loans, have a cost — you'll pay interest for the duration of your loan, though some lenders may reimburse you for some of the costs after you repay the loan.

If you don't have anyone willing to let you become an authorized user on their account or if you don't qualify for a credit-building credit card, a credit builder loan may be a good option.

How does a credit builder loan work?

A credit builder loan is not the same as a conventional loan. Instead of giving you money up front, your lender will deposit the loan amount (typically $300 to $1,000, according to the Consumer Financial Protection Bureau) into a savings or CD account that you will not be able to access until your loan is repaid. When you pay off your loan, you will receive the funds (instead of getting the money first and paying it off later).

When you make the deposit, you may be required to pay a one-time administration fee to open the loan.

Credit builder loans, like secured cards, use money in the bank as collateral. As a result, credit builder loans are less risky for lenders because they require you to save the money before you can access it. This may appear counterintuitive, but keep in mind that the sole purpose of credit builder loans is to demonstrate your ability to make timely payments, which are then reported to credit bureaus (Experian, Equifax and TransUnion).

Credit builder loans aren't good for your monthly cash flow, but they can help you establish credit.

When you pay off your loan, you receive the money that was originally deposited into the savings account or CD, as well as a portion of the interest you paid back.

Where to get a credit builder loan and what to consider?

Smaller financial institutions, such as credit unions and community banks, as well as online lenders, typically offer credit builder loans. Digital Federal Credit Union and 1st Financial Federal Credit Union are two options that provide reasonable terms, such as low interest rates and the ability to receive a refund on interest paid. A credit builder loan is unlikely to be available at a major bank such as Citi or Chase.

If you want to open a credit builder loan, look online for a variety of options and compare their terms.

When deciding which loan to open, consider the following:

1. Administrative fee: Consider if you’ll incur an account set-up fee, roughly $9 to $25.

2. Loan size: Consider how much money you can comfortably put into a savings or CD account. (You won’t be able to touch it for six to 24 months.)

3. Monthly payment: Keep in mind that the larger the loan, the higher the monthly payment. It’s important to consider how much you can afford to pay each month.

4. APR: These loans have a fixed interest rate, which ranges from 5% to 16% depending on the lender and loan size, so shop around for the best rates. Digital Federal Credit Union, for example, charges a low 5 percent APR, whereas Self charges up to a higher 16 percent APR.

5. Whether you’ll receive interest charges back: Some lenders, such as 1st Financial Federal Credit Union, may refund you a portion of the interest charges you paid if you make on-time payments.

How a credit builder loan helps your credit score?

A credit builder loan is a fixed-rate installment loan, similar to a personal loan, auto loan, or mortgage. Payments made on your credit builder loan are reported to credit bureaus and can assist you in establishing a credit score.

Because payment history is the most important factor in your credit score, it's critical to make on-time loan payments so you can build up to a good credit score over time.

According to FICO, in order to have a credit score in the first place, you must have at least one account open for six months or more and an account that has been reported to the credit bureaus within the last six months. Fortunately, credit builder loans have a minimum term of six months, which meets both of those requirements as long as you make consistent payments.

A credit builder loan can help you establish other good money habits, such as saving for a goal, if you're new to credit. This can help you get ready to apply for other financial products, such as credit cards or personal loans.

Bottom line

While credit builder loans can help you establish credit, they are not CNBC Select's top recommendation for credit newcomers due to the various fees and inability to access the money from your loan until it is paid off.

Consider other options before opening a credit builder account, such as becoming an authorized user on a family member or close friend's credit card account or opening a secured card, such as the Capital One® Secured MasterCard®. In contrast to a credit builder loan, which does not allow you to access your funds until it is repaid, secured cards allow you to deposit money and receive an extension of credit equal to the deposit.


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