As a product category, credit builder loans (CBLs) are designed as safe and user-friendly tools. They provide access to inexpensive installment debt that directly improves 60% of credit profiles. That said, they work differently than normal loans.

Misconceptions can lead to frustration, and some lenders have opaque terms and conditions, or unreasonably high interest. It's important consumers understand CBLs (i.e. structure, types, cash requirements), their purposes, and the specific details surrounding an offer before signing.

Key Takeaway

Used correctly, credit builder loans help consumers with limited or damaged credit build 60% of their profile with low-cost installment debt. However, consumers should note that most CBLs distribute funds at the end of the loan in order to accept subprime borrowers, and some lenders impose unreasonable strict conditions and inappropriately high interest.

Pros

Credit builder loans offer a number of benefits, but the 7 pros below stand out as key value drivers for most consumers.

#1 Build 60% of Credit Profile

Understand that credit builder loans are secured personal loans, but different. As such, they impact 3 of 5 credit factors known as payment history (35%), credit mix (10%), and account age (15%). They also impact new credit (10%), but not differently than any other account type.

Each installment payment adds a positive mark to payment history (35%), and the progressive addition each month has a compounding positive impact.

Because CBLs are installment credit, they contribute 50% of possible credit types to the profile's credit mix (10%). Many borrowers fall into the trap of relying entirely on credit cards (revolving credit), which is an easy mistake to make.

Using CBLs establishes accounts that appear up to 10 years on credit reports, even after they've been paid off.

Finally, the date of first reporting becomes an anchor on credit profiles whose value grows over time. Account age (10%) consists of the average age of all accounts a consumer has on his/her report, as well as the initial date of the oldest account.

Account age is the reason why we recommend consumers take out a CBL as quickly as possible.

#2 Easy Approval by Design

Approximately 30% of credit builder loan lenders do not check credit reports. They can do this because they use savings-based collateral that effectively eliminates the risk of default.

Moreover, they use alternative creditworthiness metrics such as employment and income to determine borrower reliability.

Another ~10% of lenders check credit, but they use soft inquiries that don't appear on credit reports or hurt the profile.

Together, this means about 40% of lenders don't check credit. Credit builder loans' design makes them easy products to get approved for.

#3 Prevent Unpleasant Surprises

The benefit of CBLs is improving credit, and the benefits of building credit impact almost every aspect of Americans' financial lives. From renting and job hunting to obtaining home and auto loans, personal credit is consumers' fundamental financial asset.

Good credit facilitates almost any transaction, and more importantly, prevents unpleasant surprises and the stress that comes with denials and high rates.

#4 Penalty-Free Cancellation

Good credit builder loans offer penalty-free cancellation, which means the borrower can end payments and recover funds paid into deposit without paying a fee.

No-fee cancellation adds a huge amount of value and is unique to credit-builder loans, which is why they exist as a distinct loan category.

Free cancellation is different than early payoff. Most personal loans allow early payoff, but they cannot afford cancellation because the funds have already been distributed to the borrower.

Because CBLs distribute funds at the end of the loan, they do not suffer a loss when the borrower cancels.

Penalty-free cancellation is a major advantage for borrowers, especially those who are new to credit and want the flexibility to change their mind.

#5 Automatic Savings

The standard CBL structure, called payment-secured, creates savings automatically. At the start of the loan, the lender deposits the full amount of the loan into a secured account.

The borrower makes installment payments against that balance, and recovers the full amount at the end of the loan.

In other words, each installment acts as a chunk of savings set aside for the future.

#6 Flexible Cash Requirements

A major concern for many borrowers is that CBLs essentially function opposite of normal loans because they distribute funds at the end of the loan. Borrowers with poor credit look for a loan that will accept them and provide funds.

One type of credit builder loan, called unsecured, offers money up front and flexible eligibility criteria.

#7 Solves Several Problems at Once

Perhaps the least understood but most powerful benefits is that CBLs solve multiple problems, in advance, with one product.

The outdated approach to credit building usually suggests consumers obtain costly secured credit cards. The issue with this is that they completely ignore credit mix. CBLs provide installment debt to diversify profiles.

Another common frustration is lenders imposing high rates on car/home loans due to the absence of mature installment credit. Consumers may have several credit cards, but this is revolving credit and does not reflect the same maturity as installment debt. CBLs help ease lenders' concerns.

Even after payoff, installment debt demonstrates maturity over time as an "inactive" account.

Finally, consumers that use secured credit cards may face issues if they use common options. Lenders can interpret account names to decipher whether the card is secured. If it is, this may signal riskiness.

Credit builder loans, however, will appear with the same size and terms as a normal personal loan, which reinforces their credibility.

Cons

Most credit builder loans disadvantages come from misconceptions and bad lenders, but the 7 cons below represent the most frequent frustrations consumers face.

#1 Money Received at End of Loan (Usually)

Two of three CBL types distribute funds at the end of the loan. There are distinct advantages to this structure such as automatic savings, easy approval, and spending guardrails, but unaware borrowers can be understandably frustrated to learn their funds arrive after they make payments.

In fact, misunderstanding this point can cause more financial stress than before the CBL. Borrowers in need of cash can end up having a monthly installment in addition to the original funding need.

For this reason, it's worth restating that payment-secured and fully-secured credit builder loans distribute funds at the end of the loan term.

#2 Missed Payments Still Hurt Credit

CBLs are loans like any other, and missing a payment will damage your credit. Some borrowers mistakenly assume delayed principal distribute and the absence of cancellation fees means the a missed payment won't impact their payment history.

This assumption is erroneous. Credit builder loans work because they report like normal loans. The only difference is their use of collateral.

#3 1—6 Months for Results

The reality of credit is that some consumers see results within a month, but both repair and building results usually require several months. The reason is that credit reflects consumer habits, and habits require time to assess.

More specifically, each new account automatically hurts reports due to a credit factor called "new credit." New credit reflects the idea that any request for debt is inherently risky because it implies a need for money.

New credit appears on hard inquiries on credit reports. A hard inquiry remains for 12 months but diminishes in importance over that period.

When consumers open a credit builder loan, they can expect the negative impact of the new account to diminish enough in 6 months to get a reliable assessment CBL benefits.

#4 Slow Payouts are Possible

Personal loans often make a selling point of the speed with which they distribute funds. Because CBLs distribute (aka payout) at the end of the loan, they require an average of 2 - 4 weeks.

However, some lenders have a more aggressive stance on payouts and may delay up to 2 months (8 weeks). They often justify the additional delay with claims of fraud detection.

#5 Membership fees not in APR

Not all lenders require membership, but many digital lenders lean on this structure because it provides a means to charge for multiple services without including the fee in their legally-required APR calculation.

This is a distinct disadvantage, but it's linked to specific lenders and not to credit builder loans themselves. The unavoidable fees (origination & interest) are always included, but avoidable fees such as late payment and payout are not included.

#6 Initial Drop Possible

A common frustration for borrowers is score plummets immediately following credit builder loans. This is a phenomenon that occurs because of the "new credit" factor. Any time a borrower obtains new debt, they automatically appear more risky.

We refer to this as the early part of the credit builder wave, shown in the image below.

#7 Less Effective on Strong Profiles

Credit is a question of trustworthiness, but it's a relative concept. This means each American is only trustworthy if other Americans are less trustworthy. In other words, it's a numbers game with a statistical average.

Weak profiles can improve more quickly than strong profiles because it takes less effort to be "better" than the worst, but it takes much more to be better than the average.

Credit builder loans are no exception. They work best on average and below average profiles, regardless of interest and other components.