Credit Builder Loans vs. Personal Loans: Everything You Need to Know

Unlike with traditional personal loans, credit builder borrowers pay the loan first and receive the money later

Fact checked by Suzanne KvilhaugReviewed by Andrew SchmidtFact checked by Suzanne KvilhaugReviewed by Andrew Schmidt

If you need to build credit, one way is through a loan. You might be able to use a credit card or personal loan to accomplish this purpose, but a credit builder loan might make more sense.

Here’s what you need to know about a credit builder loan vs. a personal loan.

Key Takeaways

• A personal loan provides you with a lump sum of funding after you are approved for a loan, which you pay off over time.
• With a credit builder loan, the lump sum is held in a separate account, which you receive after the terms are met.
• Both types of loans can potentially help you improve your credit score.
• A credit builder loan is specifically designed to help a borrower build a credit history or rebuild a poor credit score.

Credit Builder Loan vs. Personal Loan: An Overview

A standard personal loan works by providing a borrower with a lump sum of funding at the beginning of the loan term. Over time, the borrower repays the debt with interest, making payments in regular installments.

On the other hand, a credit builder loan provides borrowers with the funds at the end of the term (i.e., after all payments have been made).

While both a credit builder and personal loan can help you potentially improve your credit situation, they have different intended purposes.

Credit Builder Loan

A credit builder loan is usually offered to someone who doesn’t have a credit history or who has such a sparse history that they are essentially “unscorable.” Using a credit builder loan to rebuild a credit score is also possible if you have poor credit.

In many cases, a credit builder loan works as follows:

• Your lender puts the loan amount in a separate account, such as a certificate of deposit (CD).
• You make regular installment payments to the lender, paying off the loan, including interest payments.
• After the loan has been paid off, the money in the separate account is given to you.

It’s important to note that a credit builder loan is still a loan, so you’re still paying interest. You just make all of your payments before receiving the funding. Credit builder loans can have terms typically ranging from six to 24 months.

Before getting a credit builder loan, consider how long you can wait for the money. Also, since you’re still paying interest, you’ll ultimately pay more overall than the amount you receive, even though you don’t get the money until after the terms are fulfilled. The longer your term, the more you’ll pay in interest. Depending on your situation, getting a shorter loan term might make the most sense if you just need to build credit.

How to Qualify for a Credit Builder Loan

Some credit builder loans don’t require a credit check, but you might still be subject to one—just as with any other type of personal loan. Even if you have no credit history or poor credit, you might still be able to get a credit builder loan. However, you might need to show sufficient proof of income to receive the loan.

In general, you can expect to provide proof of your identity (typically using a state-issued ID), and you might need to provide bank statements or pay stubs to establish your income. It’s also worth noting that you might be able to get a lower interest rate with a credit builder loan than you would with a personal loan, especially if you have a low credit score.

Pros

• You can qualify with no or poor credit.

• Potential for lower interest rates

• Some lenders won’t perform a hard credit inquiry for a credit builder loan.

Cons

• Late or missed payments can negatively impact your credit score, even though you don’t have access to the money you’re borrowing right away.

• You will likely need to pay administrative fees and other costs, in addition to interest.

• You must wait until the end of your loan term to receive your lump sum.

Personal Loan

On the other hand, a personal loan typically denotes a more traditional loan. You apply for the loan and receive your funding upfront, usually as a lump sum. Over time, you make regular payments of the principal plus interest until you’ve paid off the amount you borrowed.

Most personal loans are unsecured, meaning you don’t need to provide collateral, such as a car or real estate, that the lender can repossess if you fail to fulfill your obligation. A personal loan might have higher interest rates than other types of loans due to their unsecured nature. Borrowers with poor credit who receive personal loans might find the interest rates quite high.

Many personal loans are fairly flexible, allowing you to choose terms of 12 months to seven years (or more).

How to Qualify for a Personal Loan

Credit requirements might be more stringent for a personal loan than for a credit builder loan. You generally need to be pre-qualified with a soft credit check, and then the lender will make an offer. Once you accept the offer, you fill out an application, and a hard credit inquiry is made. That hard inquiry might impact your credit score.

Note that pre-qualification doesn’t mean that you’ll receive the amount you initially applied for or the interest rate you were quoted. The final terms of the loan will be revealed before you accept. Read them carefully so you understand what to expect.

Generally, you need to provide proof of income and documentation verifying your identity. You might need to provide bank statements to qualify. The amount of money you receive will be based on your income, current debt balances, credit score, and other criteria set by the lender.

Pros

• Fast funding, which you might get as soon as the next business day.

• It’s possible to build a credit history or improve your credit when you make on-time payments.

• Personal loans are flexible and can be used for many different purposes.

Cons

• Interest rates might be higher on unsecured personal loans.

• Most personal loans come with fees, including administrative fees, in addition to interest.

• You usually need an established credit history to qualify for a personal loan.

How Do People Use Personal Loans?

Investopedia commissioned a national survey of 962 U.S. adults between Aug. 14, 2023, to Sept. 15, 2023, who had taken out a personal loan to learn how they used their loan proceeds and how they might use future personal loans. Debt consolidation was the most common reason people borrowed money, followed by home improvement and other large expenditures.

Key Differences: Credit Builder Loan vs. Personal Loan

The biggest difference between a credit builder loan and a personal loan is when you get the money. With a credit builder loan, you don’t receive the money until after you’ve made all of your payments. A personal loan provides you with the money upfront, allowing you to use it immediately.

A credit builder loan is specifically designed to help you establish or rebuild your credit history. Once you receive the money, you can use it for whatever you want. However, it’s not a good choice if you need cash fast.

Personal loans are intended to help you make major purchases immediately or deal with a financial emergency. Without waiting until the loan term has passed, you can secure funding much quicker.

Is a Credit Builder Loan a Good Idea?

Whether a credit builder loan is a good idea or not depends on your situation and what you’re trying to accomplish. If you’re concerned about building your credit history and you don’t qualify for a personal loan, a credit builder loan might be a good option so that you have a better chance of qualifying for other loans in the future.

Will a Credit Builder Loan Increase My Credit Score?

Whether a credit builder loan increases your credit score depends on whether you make your payments on time and in full. Generally, lenders that offer these types of loans will report your payment history each month. A positive payment history can lead to a higher credit score. On the other hand, if you miss payments, your credit score can decrease.

What Makes a Credit Builder Loan Different From a Traditional Loan?

A traditional loan provides you with the money upfront. You receive a lump sum, which you then repay over a set period of time. A credit builder loan is different because the loan amount is held in a separate account until the loan is paid off. You don’t receive the money until after making all the payments plus interest.

What Happens When You Pay Off a Credit Builder Loan?

After you pay off a credit builder loan, you receive the lump sum. You might get a little less, depending on interest and fees. But if you’ve made your payments on time and in full, you should also have a higher credit score (or have established your credit history) when you pay off the credit builder loan.

Can You Be Denied for a Credit Builder Loan?

It’s possible to be denied for any type of loan, including a credit builder loan. While your poor credit score or nonexistent credit history might not be grounds for denial in this case, if you can’t prove sufficient income for the loan, you might be denied.

It’s important to understand the criteria for any loan before you apply.

The Bottom Line

A credit builder loan could be desirable if your primary goal is to establish or rebuild your credit. It might be worth the cost of interest and fees if you can use a credit builder loan to improve your credit situation, allowing you to take advantage of better rates and other benefits down the line.

On the other hand, a personal loan might make more sense if you can qualify and you need money upfront for a major purchase, debt consolidation, or an emergency.

Carefully consider your situation and financial goals before deciding which type of loan to pursue.

Read the original article on Investopedia.