If you have a poor or non-existent credit history, it can be difficult to secure favorable loan terms, a student loan, or even a traditional credit card with a reasonable interest rate. A lack of positive payment history can also worsen your credit score and put many of your personal finance goals out of reach.

Credit-builder loans are designed to help those with poor credit or a limited credit history demonstrate an ability to make on-time monthly payments. But you should be aware that a credit-builder loan is a type of personal loan that works differently from a traditional loan.

Here’s what you need to know about credit-builder loans and how to leverage them to improve your credit profile.

How does a credit-builder loan work?

When you get a personal loan, the lender provides a lump sum upfront that you pay back over the loan term in fixed monthly payments that include interest. Sometimes called installment loans, this type of unsecured loan can be more risky for lenders, so qualifying usually requires a good credit score.

In contrast, credit-builder loans work by holding the upfront deposit in what essentially amounts to a locked savings account. Once you’ve completed your loan payments, you’ll receive access to the funds in the savings account. This helps with building credit because the lender reports that you’re making on-time payments to at least one of the three major credit bureaus, bolstering your FICO score.

Making on-time payments is the most heavily weighted factor in your FICO score. It becomes part of your credit report alongside your existing debt-to-income ratio and your credit account mix and utilization.

Read more: What credit score do you need for a personal loan?

What's the maximum amount offered in a credit-builder loan?

The loan amount typically offered for a credit-builder loan is much smaller than other loans. You’ll find credit-builder loans generally come in $300 to $1,000 increments with a loan term of anywhere from six months to 24 months. Interest rates can vary and some lenders offer more generous loan terms.

For example, Digital Federal Credit Union is an online lender that offers credit-builder loans. If you take a credit-builder loan for their maximum loan amount of $3,000 at 5% APR (annual percentage rate) over a 24-month term, your estimated monthly repayments would be $130.71. At the end of the loan term, you’d receive access to the principal of $3,000 plus any dividends the bank account has earned.

Who should consider credit-builder loans?

An estimated 16% of Americans have no credit score or credit profile with any of the three credit bureaus, which can deeply impact their ability to get a loan, purchase insurance or hold a credit card. These are the borrowers for whom a credit-builder loan offers the biggest impact.

Those with bad credit who are seeking to improve a low credit score or rebuild a positive credit history can still benefit from credit-builder loans, but will see a smaller impact overall. According to a 2020 Consumer Financial Protection Bureau study, for those who had existing debt, credit-builder loans increased credit scores an average of 60 points.

Where can I get a credit-builder loan?

Credit-builder loans aren’t offered at every financial institution, and you should thoroughly vet any online lenders that offer these loans. Credit-builder lenders are typically confined to credit unions, community banks, or low-income lenders that are part of the Community Development Financial Institutions Fund.

Credit unions, which may charge a small fee for membership or require you to open a savings or checking account, and community banks share a focus on consumer education. Their commitment to serving local communities makes them more likely to offer loans that build credit for underserved populations.

Read more: Is a personal loan right for me? 3 questions to ask.

How to qualify for a credit-builder loan

The good news is, you don’t need a credit history or a good credit score to qualify for a credit-builder loan. Some credit-builder lenders don’t require a credit check, but your lender may review your banking history, how much debt you have, or your income to ensure you can make fixed payments.

Here are a few things you may be asked to provide when applying for a credit builder loan.

• Social Security number

• Employer information

• Proof of mortgage or rental payment

• Proof of income (pay stubs or tax returns)

• Checking or savings account balances

• References

• Proof of identity and Social Security number

To verify your banking history and screen for bounced checks, lenders use something called the ChexSystem. ChexSystem is actually a consumer reporting agency that’s required by federal law to offer you a free report every year, which you can request here.

Read more: How to apply for a personal loan

4 more ways to build credit

If the idea of having to pay interest and then waiting for the loan proceeds rubs you the wrong way, here are a few other ways you can build credit without a credit-builder loan.

1. Ask to be an authorized user

If you have a friend or family member with good credit, they can help you establish a credit history by adding you as an authorized user to their credit card. They don’t even have to give you access to the credit card — you benefit just by close association with their financial reputation.

2. Get a secured credit card

A secured credit card does get you access to a line of credit, but you’re usually required to pay a security deposit, which is often refundable, up front. For example, Bank of America offers a secured credit card with no annual fee. But it requires a security deposit of $200 and you’ll pay higher interest rates.

3. Consider lending circles

Lending circles are community groups designed to empower lending through a shared pool of money. Each member makes monthly contributions and then takes turns borrowing the money. This approach can be a great way to build a credit history as long as the organization reports payment history to the credit bureaus.

4. Secured personal loan

While your lack of credit history or low credit score might not make you a great candidate for an unsecured personal loan, you may still be able to get a loan by offering collateral. However, you will need to make on-time monthly payments to avoid negative impacts to your credit and you’ll pay a higher interest rate than you would with a credit-builder loan.

Credit-builder loan FAQs

Do credit-builder personal loans get reported to credit bureaus?

Check the fine print on the loan terms to ensure the lender is reporting to all three major credit bureaus — Experian, TransUnion, and Equifax. While it’s acceptable to report to just one, you want to make sure your credit report reflects robust credit scores across the board.

Should I pay off a credit-builder loan early?

The point of a credit-builder loan is to maximize your positive payment history, so you want as many on-time payments on your credit report as possible. Paying off a credit-builder loan early defeats that goal because you’ll make less payments overall, so an early payoff isn’t advisable in most situations.

Are credit-builder loans the same as no-credit check loans?

While credit-builder loans don’t usually require a credit check, they’re different from no-credit check loans like payday loans. Payday loans are short-term loans that charge high interest rates and have short repayment periods of 30 days or less. Payday loans are associated with a cycle of debt and poor credit and often don’t report to credit bureaus unless you default on the loan. So they aren’t a credit-building tool.

Read more: Payday loan vs. personal loan