Editorial Policy

Credit-builder loans help rebuild or establish credit

Susan Johnston Taylor

June 15, 2015

Whether you’re trying to build credit for the first time or to repair credit following a foreclosure or other difficulties, a little-known option called a credit-builder loan or a starter loan can help.

“A credit-builder loan can be for someone starting out or somebody who’s on the rebound who may have had some financial problems with creditors in the past,” says Bruce McClary, a spokesperson for the National Foundation for Credit Counseling.

One out of five credit unions offer this type of loan, reports the Credit Union National Association (CUNA), and the average loan balance is $1,146. As your lender reports your payments to the credit bureaus, it helps build or improve your credit file. “Down the road, the hope is that this person would have a relationship with the credit union and be able to get a mortgage or an auto loan,” says Michelle Dosher, managing editor at CUNA.

However, while diversity of credit lines is factored into your credit score, McClary cautions against “borrow[ing] money for the sake of borrowing money…  You don’t want to upset the apple cart by piling on too much debt for the sake of diversifying.” Take out a credit-builder loan for a specific financial need. If you don’t actually need a loan, consider other options such as a secured credit card or becoming an authorized user on someone else’s credit card.

Here’s how to get started with a credit-builder loan.

1. Find a credit union that offers credit-builder loans. The United States has nearly 7,000 credit unions, according to CUNA, so you should be able to find several options in your area. McClary says opening an account at a credit union may cost as little as $5 to start. Before you join, ask if the credit union offers credit-builder loans to its members.

2. Compare your options. Dosher suggests meeting with the staff at each credit union to find your best loan option. For instance, do you need a co-signer? Dosher says this varies by credit union. Also ask about the interest rate and repayment terms. With a starter loan, you’ll typically pay a higher interest rate than someone with good credit, but “don’t assume that just because you’re in the market for starter loans, you can’t competitively shop around to get the best deal,” McClary says. He adds that 17 to 21 percent is typical for this type of loan, but the rate can go higher or lower depending on the lender. Some credit unions may also require you to put some collateral in a savings account. “That helps encourage a habit of saving,” McClary explains.

3. Make timely payments. Because most lenders report to the credit bureaus (and make sure yours will) and the goal of these loans is to build credit, you don’t want to miss any payments. “The key to make this a very useful tool is, once it’s time to start paying, make sure you focus on making payments on time and try to pay the balance off as quickly as possible,” McClary says. “If you slip up, it’ll go from being a helpful tool to something that’s going to cause more damage than you had hoped.” Most importantly, make sure that the starter loan fits within your budget. If you manage to repay your loan early (assuming there’s no prepayment penalty), you can also save on interest.

Note that you can put the borrowed proceeds from the loan into a special checking account created just for the purpose of repaying the loan. But you have to have the discipline not to touch the account for anything but monthly loan repayments.

When used responsibly, a credit-builder loan can help prepare you for other types of credit products in the future.