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Credit builder loans can help you establish credit but they come at a cost—here's how to know if you should get one

Credit builder loans can help you build credit, but they're not a traditional loan. Here's how credit builder loans work so you can decide if one is right for you.

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Establishing credit isn't always easy, especially since many lenders require you to have a credit history in order to open an account. This makes it hard for credit newbies to obtain typical forms of credit, such as credit cards, but there are some alternative options.

A credit builder loan is one option that typically doesn't require a credit history. This loan is specifically designed to help you build credit as you make payments toward your loan. However, just like other loans, credit builder loans come at a cost — you'll pay interest throughout the length of your loan, though some lenders may reimburse you for some of the costs after you repay the loan. 

A credit builder loan may be a good fit if you don't have someone willing to let you become an authorized user on their account or you can't qualify for a credit-building credit card.

Below, CNBC Select reviews how credit builder loans work so you can decide if it's a good choice for you.

How does a credit builder loan work

A credit builder loan is different from a typical loan. Instead of you receiving money upfront, your lender deposits the amount of the loan (typically $300 to $1,000 according to the Consumer Financial Protection Bureau) into a savings or CD account that you can't access until your loan is repaid. When you pay off your loan, that's when you'll get the money (instead of getting the money first and paying it off later).

To open the loan, you may be required to pay a one-time administration fee when you make the deposit.

Similar to how secured cards work, credit builder loans hold money in the bank as collateral. For this reason, credit builder loans are less risky for lenders since they require you to save up the money first before you can even access it. This might seem backwards, but keep in mind that the sole purpose of credit builder loans to demonstrate your ability to make timely payments that then get reported to the credit bureaus (Experian, Equifax and TransUnion).

Credit builder loans aren't great for your monthly cash flow, but they can be instrumental in helping you establish credit (which we discuss more below).

Once you pay off your loan, you receive the money that was originally put into the savings account or CD, and you may receive a portion of the interest you paid back as well. 

Where to get a credit builder loan and what to consider

Credit builder loans are generally offered by smaller financial institutions, such as credit unions and community banks, as well as online lenders. Digital Federal Credit Union and 1st Financial Federal Credit Union are two options that offer decent terms, including low interest rates and the ability to receive a refund on paid interest. You usually won't find a credit builder loan at a major bank like Citi or Chase.

If you want to open a credit builder loan, shop around online for a variety of options and compare the terms of each.

When deciding which loan to open, consider the following:

  • Administrative fee: Consider if you'll incur an account set-up fee, roughly $9 to $25.
  • Loan size: Consider how much money you can comfortably put into a savings or CD account. (You won't be able to touch it for six to 24 months.)
  • Monthly payment: Keep in mind that the larger the loan, the higher the monthly payment. It's important to consider how much you can afford to pay each month.
  • APR: These loans incur interest at a fixed rate, generally 5% to 16% depending on the lender and size of the loan, so look for the lowest rates. For instance, Digital Federal Credit Union charges a low 5% APR while Self charges up to a higher 15.65% APR.
  • Whether you'll receive interest charges back: Some lenders may refund you a portion of the interest charges you paid, such as 1st Financial Federal Credit Union, which refunds 50% of interest after you make on-time payments.

How a credit builder loan helps your credit score

A credit builder loan is an installment loan with fixed monthly payments, similar to a personal loan, auto loan and mortgage. Payments you make toward your credit builder loan are reported to the credit bureaus and can help you establish a credit score.

Since payment history is the most important factor of your credit score, it's important to maintain timely payments on your loan so you can build up to a good credit score over time.

In order to have a credit score in the first place, you'll need to have at least one account opened for six months or more and an account that's reported to the credit bureaus within the past six months, according to FICO. Thankfully, credit builder loans start at a minimum of six months, thereby fulfilling both of those requirements as long as you make consistent payments.

If you're new to credit, a credit builder loan can help you establish other good money behaviors, such as saving for a goal. This can prepare you for opening other financial products, such as credit cards or personal loans.

Bottom line

While credit builder loans can help you establish credit, they are not CNBC Select's top choice for credit newbies due to the various fees and inability to access the money from your loan until your loan is paid off.

Before you open a credit builder account, consider alternative options, such as becoming an authorized user on a family member or close friend's credit card account or opening a secured card, like the Capital One® Secured Mastercard®. Secured cards allow you to deposit money and receive an extension of credit equal to the deposit, unlike a credit builder loan that doesn't allow you to access your funds until it's repaid.

There are even some credit cards that don't require a credit history, such as the Deserve® EDU Mastercard for Students and the Petal® Visa® Credit Card (though if you have a credit file, it does factor into the credit decision).

But if you're unable to use any of these alternatives, you may want to consider a credit builder loan. Make sure you review the terms of the loan and choose the lowest-cost option so you can build credit at a minor cost.

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Information about the Capital One® Secured Mastercard® and Petal® Visa® Credit Card has been collected independently by CNBC and has not been reviewed or provided by the issuers of the cards prior to publication.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the CNBC Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.