To build credit, you need credit, which can make it a frustrating task for those just starting out or trying to add a mix of credit types to their financial profile. Lenders are typically less likely to approve someone if they have low credit scores or don’t have a thick credit file. If you find yourself in this position, a credit-builder loan might be worth considering.

A credit-builder loan is designed to help people who have little or no credit history build credit. That’s why credit-builder loans go by other names like “Fresh Start Loans” or “Starting Over Loans.” Growing your score has lots of benefits, like making approval for credit cards and loans, and at better rates, more likely.

Credit-builder loans do not require good credit for approval. However, they do require that you have enough income to make payments. When applying, you might need to provide information on your employment history, income and balance in your checking or savings account.

With a traditional loan, the borrower gets the money first and pays it back over time. With a credit-builder loan, the lender keeps the total loan amount while the borrower makes payments. Once all the payments have been made, the borrower receives the full loan amount. Holding the money in a secured account until the loan is fully repaid acts as a safety net for the lender that’s taking on risk if you have no experience with credit or low credit scores.

During the loan terms, your on-time payments are reported to at least one major credit bureau, but you should look for loans that report to all three (Equifax, Experian and TransUnion) if possible. Since FICO and VantageScore pay the most attention to your payment history when compiling scores, it’s crucial to make your payments on time. Having your on-time payments reported helps build your credit and shows you can handle a credit account.

Another benefit of a credit-builder loan? At the end of the loan’s terms, you’ll have a reserve of funds that can serve as an emergency fund or go toward another important savings goal.

There are two groups of people who might want to consider a credit-builder loan:

Credit-builder loans can help people who are “credit invisible” — they don’t have a credit score or report — get on the scoring radar and can be a good choice for credit newbies. Some 28 million Americans fall into this category, according to a 2022 report by Experian and management consultating firm Oliver Wyman. ^[0]

While people who are credit invisible can use debit cards or cash, they have limited access to financial products and services, which can pose real obstacles as they try to purchase a car or home or get approved for a credit card or apartment lease.

There are 21 million Americans who are considered “unscoreable” because their limited credit file does not include enough information to produce a credit score, according to the Experian and Oliver Wyman report. A credit-builder loan can help people with a thin credit file by adding another account type to their portfolio.

While not the most important factor, credit mix is used to calculate credit scores. Having a credit history with different kinds of accounts can build your scores, and if you have a record of on-time payments with your other credit this could be a low-risk way to simultaneously grow your score and reach a savings goal.

1. Research and compare lenders. Look for a credit-builder loan with a payment and term you can comfortably handle. Stretching your budget will only raise your risk of missing a payment and damaging your scores. Choose a loan that reports payments to all three major credit bureaus, if possible.

2. Make payments on time. If you pay the loan as agreed, you build up good data on your credit reports. But a payment more than 30 days late will also go on your reports and can seriously hurt your scores.

3. Monitor your credit score. Use a personal finance website such as NerdWallet to get a free credit score. NerdWallet updates your score weekly; watch the overall trend of your score, but don’t obsess over tiny movements.

4. Decide what to do with your loan proceeds, plus any interest. At the end of the loan term, you get the money — and likely a better credit score. If possible, use that money as an emergency fund. Having a few hundred dollars saved can insulate you from unexpected expenses that otherwise might lead to debt or missed payments and score damage.

Credit-builder loans are not widely advertised and are generally offered by smaller financial institutions.

Credit unions or community banks: Credit unions typically have membership requirements, such as living in a particular county, working for specific companies, worshiping in a certain church or making a small charitable donation. But they may offer the lowest interest rates. It pays to check.

Online lenders: An online search can bring up lenders that offer credit-builder loans. Not every lender is licensed in every state, though, so it’s important to check that. In addition, payments, terms and APRs vary widely.

Lending circles: One practice that can be used among families or friends is a credit-building plan offered through lending circles where participants get interest-free “social” loans and payments are reported to the credit bureaus. The nonprofit Mission Asset Fund runs a lending circle program, and other companies also offer versions of this practice. Availability is limited.

• If you have money in the bank, you may have another option for an installment loan: a share- or certificate-backed loan. In that case, a deposit you already have at the financial institution is the collateral, and that money is frozen until the loan is repaid (or it may be incrementally thawed, as the loan is repaid). So if you have funds on deposit at a small bank or credit union, it may be worth asking if you can borrow against them to help reestablish your standing. Other lenders may allow you to borrow against the value of your car.

• If it’s an option, you could also ask a friend or relative who has excellent credit to add you as an authorized user on a credit card. As an authorized user, the account history of that card will be added to your credit report. The primary user doesn’t have to actually give you the card, and you don’t need to make charges — just being associated with their stellar credit reputation helps yours.

If you are trying to build credit and need the proceeds of a loan immediately (for debt consolidation, for example), you will probably need to take an unsecured personal loan. That means the lender has no collateral, just the strength of your credit history, to rely on. If your credit is damaged or thin, you’ll pay higher interest rates, sometimes as much as 36%, which tends to be the ceiling for most personal loan lenders that check credit.

Some lenders will grant you unsecured personal loans without checking your credit at all, but those installment loans work much more like payday loans. The lenders may not report payments to credit bureaus, which means they are not useful if you are trying to build credit.

Credit-builder loans can be a strategy for boosting credit and saving, especially for people who are credit invisible or those who need to beef up their credit file. They may be a good idea if you have the income to make regular, on-time payments. Be wary of fees and variable APRs that could create added costs and put your credit at risk.

A credit-builder loan may not make sense if: