A credit builder loan can be an effective way to build or rebuild your credit score. With this type of loan, the borrowed amount is held in a savings account as collateral while you make monthly payments.
As you repay the loan responsibly, you establish positive payment history that can significantly boost your credit.
However, credit builder loans are not perfect and do come with some potential downsides. Looking at both the advantages and disadvantages can help you determine if this type of loan is your best option for building credit.
The Pros: Benefits of Credit Builder Loans
Here are some of the key benefits that make credit builder loans useful credit-establishing tools:
Builds Your Credit History
The number one advantage of credit builder loans is that they help establish a positive credit history. For those with no credit or damaged credit, this loan provides an opportunity to build a strong payment record from scratch.
Each on-time monthly installment payment is reported to Equifax, Transunion and Experian. As you diligently repay the loan month after month, your payment history lengthens, which is one of the most important factors in credit scores.
With responsible use over the full loan term, a credit builder loan can take you from no credit to a FICO score over 700 within as little as 12-24 months.
Qualification is Based on Income Rather than Credit
Credit builder loans are specifically designed for borrowers with poor or no credit. Therefore, approval is primarily based on income rather than your credit scores or history.
As long as you have steady verifiable income of just $800 – $1,000 per month, you can likely qualify regardless of credit standing. Lenders understand you are using the loan specifically to build credit history.
Small, Predictable Monthly Payments
These loans provide fixed regular monthly payments, usually between $25 and $50 per month. By design, the payments are affordable even on a modest income.
Knowing the payment amounts are consistent each month makes financial planning easier. The small payments help you demonstrate responsible usage without breaking your budget.
Often Feature Low Interest Rates
Compared to other loan options available to those with bad credit, credit builder loans tend to offer lower interest rates. Rates of 12-15% are common, much less than the 400%+ rates on payday loans or other predatory lending.
Of course, those with strong established credit can qualify for rates of 5% or less. But for borrowers with challenged credit, credit builder loan rates provide reasonable terms.
Easy Online Approval Process
Applying for a credit builder loan is quick and convenient through online lenders. The required information is minimal and limited paperwork is needed in most cases.
Online lenders like Credit Strong, Self Lender and Unsecured provide instant eligibility decisions. If approved, you can have funds loaded to your secured account within days.
Allows You to Save While Paying Down Debt
A unique advantage of credit builder loans is the forced savings element. The loan funds sit in your savings account while you make payments. This keeps you from spending the money while simultaneously building savings.
Your account balance grows with interest over the loan term. At maturity, the lender releases the loan amount plus interest earnings to you provided all payments have been made.
Credit Mix Impact on Scores
FICO and Vantage scoring models consider your “credit mix” when calculating scores. Mix means having different types of credit – installment loans, credit cards, mortgages, etc.
Adding an installment loan to your credit report through a credit builder loan gives you a more diverse mix than just credit cards alone, boosting your scores.
Potential to Graduate to Better Loan Options
Successfully repaying your credit builder loan on time each month demonstrates to lenders that you are now creditworthy for less restrictive, lower cost borrowing options.
Many lenders provide graduated programs that allow you to refinance into lower rate loans as your scores improve. Your strengthened credit may also qualify you for your first unsecured credit card.
The Cons: Potential Disadvantages of Credit Builder Loans
Now let’s examine some of the possible downsides and risks associated with credit builder loans:
Loan Funds Are Inaccessible During Repayment
The funds you borrow are locked in the collateral savings account until the loan is fully paid off. You cannot access any portion of the money during the repayment term, usually 24 months.
For some borrowers, not having access to their own loan funds can be frustrating. Temptation to miss payments may increase if you experience an unexpected financial crunch.
Interest Rates Are Higher Than Traditional Loans
While credit builder loan rates are lower than other bad credit options, the interest is still higher than traditional bank lending rates. Credit card interest rates today average around 16%, while credit builder loans can be 18% or higher.
Of course, those with great credit can qualify for credit cards under 10% APR and personal loans as low as 5%. But improving credit takes time.
Multiple Fees Can Increase Total Costs
Along with interest charges, lenders often charge fees for origination, loan processing, late payments, and early termination. These fees can add several hundred dollars to the total cost of the loan.
Read the fine print carefully to ensure you understand and are prepared to pay all applicable fees over and above the monthly payments.
Credit Utilization May Temporarily Increase
When your credit builder loan initially appears on your credit reports, it can negatively impact your credit utilization ratio. This measures how much of your available credit is being used.
Adding the full loan amount to your balance owed would increase your utilization. But as long as you keep credit card balances low while repaying the installment loan, your scores should still improve.
Late Payments Hurt Your Credit Building Progress
The rigid scheduled monthly payments require discipline to avoid becoming late and damaging your credit. If you fall behind on payments, late fees are assessed and your credit scores suffer.
Automatic payments help avoid issues as long as you maintain a positive checking account balance. Budget carefully so you aren’t tempted to skip payments if money is tight some months.
Loan Amounts for New Borrowers Are Low
If you have no credit history, lenders will limit your first credit builder loan to $500 – $1,000. While helpful for starting your credit journey, this low limit minimizes how much you can save while paying down the loan.
As you demonstrate on-time payments and your credit improves, you may qualify for higher loan amounts on future applications.
Locked Savings Cannot Be Easily Accessed
Since the borrowed funds are locked for the duration of the loan, they cannot act as accessible emergency savings like a standard savings account. Only borrow what you are confident you can repay on schedule.
If you lost income unexpectedly and faced hardship repaying your loan, early withdrawal of the funds is not an option. Accessing the savings requires approval to close the loan.
Can Only Have One Loan Open at a Time
You can only have one active credit builder loan at any given time, limiting how quickly you can build credit history. Each loan must be fully paid as agreed before opening another.
This restricts the loan amounts and requires waiting periods between loans. Paying off multiple smaller installment loans simultaneously accelerates credit mix expansion.
Requires Ongoing Diligent Money Management
As with any loan, signing up for a credit builder loan is a commitment. The responsibility of budgeting for on-time payments every month for up to two years requires disciplined money management habits.
Make sure you are ready for the maturity and focus needed to maximize the benefits. If not, you may become frustrated with the limitations and rigid payment schedule.
Weighing the Pros and Cons
Analyzing both the favorable and unfavorable aspects provides a balanced perspective on credit builder loans. Here are some key considerations when weighing the pros and cons:
- The credit benefits tend to outweigh the disadvantages for most borrowers with challenged credit.
- Be certain the payment amounts work with your budget to avoid falling behind and further damaging credit.
- Compare interest rates and fees to other credit building options to find the best value.
- Understand exactly how and when the money can be accessed during the loan term before committing.
- Only borrow what you can confidently repay on schedule each month. Avoid temptations to skip payments later.
- Be prepared for the maturity and discipline required to maximize on-time payments.
- View the savings requirement as a positive behavior, not a restriction. Let it build your savings foundation.
For most people needing to establish or rebuild credit, the pros seem to outnumber the cons. But carefully weigh your specific circumstances, needs and money management abilities before moving forward. Used strategically and diligently, credit builder loans can be extremely effective credit score boosters.
Tips for Maximizing Benefits and Minimizing Risks
If you determine a credit builder loan aligns well with your credit situation and financial habits, here are some tips for optimizing the benefits while minimizing the potential disadvantages:
- Compare loan terms from multiple online lenders to find the best loan amount and rates for your situation.
- Understand all fees involved before committing so surprises don’t sabotage your repayment budget.
- Only borrow what you can confidently afford based on your income and budget. Don’t sacrifice other priorities simply to get a larger loan amount.
- Use auto-debit from your checking account to ensure you never miss a payment due to forgetfulness.
- If your income fluctuates, keep at least 2 monthly payments in your checking buffer as a precaution.
- Pay down balances on any credit cards you have to lessen the credit utilization impact when the installment loan is reported.
- Consider the loan savings account an untouchable emergency fund only to be accessed once the loan is paid off.
- Sign up for account alerts from the lender so you are notified of any issues with scheduled payments.
- Check your credit reports periodically to ensure on-time payments are being accurately reported.
- If financial hardship arises, communicate promptly with the lender to discuss options rather than letting payments lapse.
- After successfully completing your loan, let the funds continue earning interest in your savings account to build your financial foundation.
With proper research, planning and diligent money management, a credit builder loan can be a smart strategic choice for establishing strong credit.
Just be objective when assessing if it aligns with your situation. If so, use the loan responsibly to maximize benefits and realize your credit-building goals.