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