Published: 14 August 2023
Updated: 9 February 2024
Author: Noah Gomez
Credit builder loans (CBLs) use a mix of savings-based collateral and alternative creditworthiness metrics to provide installment credit with maximum 35.99% APR to consumers with no credit history, limited credit history, and damaged credit history.
The loan adds positive payment history, credit mix, and account age to the consumer's credit report, thereby improving his/her credit profile and score.
Credit builder loans' use of collateral and alternative metrics is not the same as secured cards, which require a deposit for revolving credit. It's also not the same as secured personal loans, which require tangible collateral such as cars and homes.
The mechanics behind CBLs have heightened value for three specific profiles. The first is credit invisibles, who have to no credit history. The second is those with stuck profiles, who make consistent payments and remain under 30% utilization but don't see score improvement. The third is those with damaged credit.
CBLs work by using collateral and alternative creditworthiness metrics, but they differ by CBL type. The most common type is payment-secured, which uses collateral stored in savings. Fully-secured CBLs also use savings-based collateral, but unsecured CBLs depend entirely on alternative metrics.
In most cases, borrowers do not receive funds from the credit builder up front because the lender needs to see they're trustworthy. Some credit builder loans, called "unsecured," provide funds upfront as long as the borrower meets alternative creditworthiness requirements.
Select lenders allow you to close the loan early and recover their cash without penalty fees. This is called early closure (see below), but borrowers should keep in mind that the closure is reported to credit bureaus and limits the credit benefits of the loan.
Borrowers should expect most results within 6 months, with additional benefits up to 12 months. That said, strong credit profiles require more time because it's always more challenging to outperform the average (see below).
Let's use BMO Bank's offer for $1,000 at 12.24% over 24 months as an example. Imagine a borrower with 2 credit cards and a 500 FICO score takes the loan because she is refused for private student loans.
She would pay $47.19 per month for 2 years for a total of $1,132.46. BMO Bank would then give back $1,000 and keep $132.36. She effectively pays $132 to improve her credit and qualify for the student loans.
Flexible eligibility criteria refers to lenders' acceptance of borrowers with limited, non-existent, or damaged credit. Limited credit usually means fewer than 5 accounts, whereas damaged credit refers to late payments of 30-day or more, including charge-offs and collections.
Any loan with flexible acceptance criteria and the intention of improving borrower credit is a credit builder loan. However, most lenders reserve this name for secured loans that hold payments in a savings account until maturity, also known as payment-secured credit builder loans.
Criteria by CBL type are as follows
Flexible eligibility criteria is important for anyone with <5 accounts, late payments, or no history, regardless of credit score. A common frustration arises when borrowers with FICO 8 scores above 670 are denied for personal loans.
This occurs when the score is based on a thin credit profile that doesn't have enough content to support the credit score in the lender's assessment. A common example is children who built credit as authorized users on their parents' credit cards.
Credit builder loans' flexible criteria is therefore an advantage for anyone with no history, 4 or fewer accounts, or derogatory marks on their credit report.
Payment-secured (PSCBLs) and fully-secured (PSCBLs) credit-builders use collateral stored in savings to provide flexible eligibility criteria.
PSCBLs require the borrower make installment payments into a savings account of certificate of deposit. Once the full loan amount is deposited, the borrower receives the loan proceeds, less interest.
The money held in savings is collateral the lender can use to pay itself in case the borrower defaults. That security allows 30% of lenders to have zero requirements.
FSCBLs like First Tech CU require the borrower deposit the full amount of the loan upfront. The deposit sits in a savings account from which the lender draws payments each month.
The upfront deposit essentially eliminates risk for the lender. This collateral is what allows FSCBL lenders to have zero eligibility criteria.
Select unsecured credit builder loans such as Moneylion use membership fees as a derivative of savings-based collateral, but the majority use alternative creditworthiness metrics.
Unsecured credit builder loans (USCBLs) use alternative creditworthiness metrics to provide flexible eligibility criteria. They focus on borrower income, employment status, existing debt, personal assets, and major events like bankruptcy, rather than heavily depend on credit score.
The precise mathematical approach USCBL lenders use is proprietary, but the premise is clear. Traditional creditworthiness assessments focus heavily on past borrowing habits, which date as far back as 10 years.
This approach has a margin of error because consumer circumstances and behaviors change over time. Alternative creditworthiness metrics allow USCBL lenders to accept borrowers that traditional methods deny.
The approach is also how 10% of USCBLs can have minimum FICO 8 score requirements of only 300.
Credit builder loans improve credit primarily by establishing payment history. Each installment payment is a positive mark on the account even if the payment is held in a savings account of certificate of deposit. The accumulation of timely payment history has a progressively larger positive impact on the credit report.
Missed payments, however, will damage the account and report even if the borrower has not received any principal (as in the case of payment-secured and fully-secured CBLs).
It's important to note that a missed payment has a disproportionately large negative impact. One missed payment requires multiple on-time payments to counterbalance.
CBLs improve credit mix by adding an installment account to credit reports. Most consumer credit reports are dominated by revolving credit lines, like credit cards, because these are accounts used for everyday spending rather than purpose-driven personal loans. By adding a CBL, installment credit diversification positively impacts the credit report.
Statistics suggest reports with fewer than 5 installment accounts benefit most from this diversification.
CBLs anchor an account in time that progressively adds to average account age. The addition will initially decrease average account age, which is a common source of frustration for consumers who expect progress but see a drop in score.
This initial dampening of score is responsible for many consumers quietly giving up on credit building, and it's why having a strong plan that guides expectations is so important.
CBLs report to credit bureaus like normal personal loans and do not signal a CBL mention, which means they impact your profile and score. The practice of reporting like normal loans is truthful and shouldn't be interpreted as dishonest.
Why? Because just like secured personal loans use tangible collateral like a car, credit-builders use intangible collateral: cash. CBLs have the same collateral framework from a strictly financial perspective, opting simply for cash collateral instead of physical assets.
Credit-builders are structured to tackle the psychological and practical obstacles bad credit consumers face. The credit building paradox is a vicious cycle in which consumers must build credit to obtain debt, but need debt to build credit. Credit-builders provide a foot-in-the-door debt opportunity without requiring good credit.
Moreover, many bad credit consumers live with financial circumstances that create temptation to over-borrow and under-save. CBLs' structure provides built-in safeguards to prevent these and other poor credit management actions, which help to break the credit building paradox.
The most important unique attribute in secured credit builder loans (payment-secured or fully-secured) is that the lender holds the principal amount of the loan until maturity. This means the borrower cannot use the principal value of the loan to buy assets that appreciate.
Normal installment loans, such as personal loans and mortgages, distribute the principal amount at the start of the installment schedule.
Secured CBLs (payment-secured or fully-secured) have a built-in savings function. Consumer payments sit in a savings account or equivalent during the duration of the loan. This structure forces the borrower to set money aside rather than spend it.
Due to the time value of money, this structure costs more for the consumer than a normal loan with the same APR. The advantage to consumers is protection against temptation to spend money. Additionally, CBL APR is generally lower than other personal loans.
Credit builder loans have an average length of 24 months, but most common duration is 12, followed by 24 and 6 months. Length varies by CBL type, and benefits start to appear at different points along the timeline.
Credit builder loans usually show reliable results within 6 months. Thin files show impact as quickly as 1 month because it's easier to improve to the average than improve beyond it. Damaged and/or thick files may take as long as 12 months to show trustworthy results.
Secured CBL lenders pay out the cash collateral when the loan is closed. They carry the risk that a dishonest lender retains the principal amount of the loan unreasonably after maturity. Consumers should make sure their lender does not have a reputation for unjustly withholding funds during payout.
Credit builders have one universal cost component and 3 optional ones. The universal cost, and largest, is interest. The second is origination. The third is administrative. The fourth is subscription cost.
All these costs except subscription must legally be included in the global price—annual percentage rate (APR). However, surprises arise when borrowers don't understand how these costs impact the loan. Origination, for example, is subtracted from loan proceeds but still used as a basis for interest calculation.
As a rule of thumb, consumer should avoid APR greater than 35.99%, which is considered the threshold of predatory lending.
Getting a CBL not as simple as applying for the first one that appears. Consumers must first decide which type of credit builder is most appropriate for their needs. They also must consider:
Consumers should also consider how the CBL fits into their overall profile because a good mix of cards and loans at the right time is key to successful credit building. It's best to mimic a credit building program or simply use one like Thick Credit's plans.
1. Gomez, Noah. 2023. Review of Credit Builder Loan Offers Dataset. ThickCredit.com. Thick Credit. July 24, 2023. https://thickcredit.com/datasets/private-credit-builder-loan-offers.
Noah Gomez (founder of Thick Credit) is a transatlantic professional and entrepreneur with 3+ years experience in consumer finance education. He also has 5+ years of experience in corporate finance, including debt financing, M&A, listing preparation, US GAAP and IFRS.
Thick Credit is not a credit repair organization, a credit conseling agency, or a debtor education providor. It does not act on your behalf to communicate with credit reporting agencies or provide pre-bankruptcy credit counseling and pre-discharge debtor education for bankruptcy.
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