In this article:
- What Is a Credit-Builder Loan?
- How Credit-Builder Loans Work
- Paying Off a Credit-Builder Loan Ahead of Schedule
- Impacts to Your Credit
It's possible to pay off a credit-builder loan ahead of schedule—but doing so has none of the advantages that come with paying off other types of loan early, and there are distinct benefits to not paying it off early.
What Is a Credit-Builder Loan?
A credit-builder loan is a special type of loan designed to help people with limited or poor credit histories improve their credit scores. Available from many credit unions and some other financial institutions, a credit-builder loan is typically a loan of $300 to $1,000, with a repayment period of six to 24 months. Its goal is to let you create a pattern of timely debt payments in your credit files at the national credit bureaus (Experian, Equifax and TransUnion), and to help you save some money in the bargain.
Because on-time payments are the single biggest influence on credit scoring systems like the FICO® Score☉ and VantageScore®, making on-time monthly credit-builder loan payments will tend to improve your credit score, especially if your FICO® Score is in the fair or poor range.
How Credit-Builder Loans Work
Here are the basics on how credit-builder loans work:
When you receive a credit-builder loan, the lending institution deposits the full amount you've borrowed into a special savings account or certificate of deposit (CD), with the understanding that you will not have access to those funds until you've paid off the loan. The lender will treat the deposit as collateral and use it to pay off the loan if you fail to complete your payments.
As you make monthly payments with interest—current annual percentage rates (APRs) on credit-builder loans are about 12%—your payments are reported to the credit bureaus. Those payments will appear in your credit files and potentially benefit your credit score.
When you've paid off the loan and gained access to the account, it will contain a sum equal to the amount you borrowed. Some credit unions even deposit some or all of the interest you paid on the loan into the account as well.
Paying Off a Credit-Builder Loan Ahead of Schedule
If you need emergency access to the funds in your credit-builder savings account, you can free them up by paying off the outstanding amount of the loan off early. Doing so largely defeats the purpose of a credit-builder loan, however:
- Because the goal of a credit-builder loan is to make timely payments appear on your credit files and thus improve your credit history, there's an advantage to making as many of those payments as possible under the terms of your loan agreement.
- And while paying off other installment loans early can reduce your interest charges, with credit-builder loans, you're sometimes paying the interest to yourself, so there's no real benefit there, either. And even if you don't get any interest returned to you, the interest is the price you're paying for that lengthened credit history—and, ideally, improved credit scores.
If you're forced to pay off a credit-builder loan early, the good news is that there likely will be no financial penalty for doing so. It's theoretically possible for a credit-builder loan to have a prepayment penalty—a charge you must pay if you pay the loan off ahead of schedule—but most credit-builder loans do not. (Ask before you open the loan and go elsewhere if a prepayment penalty is required.)
Impacts to Your Credit
Paying off a credit-builder loan early can limit its positive impact on your credit scores, but it doesn't have any negative credit impacts. As with any loan you pay in full—early or according to the original repayment schedule—your credit-builder loan will appear on your credit report as a paid-off account in good standing.
The only way a credit-builder loan can harm your credit scores is if you make late payments, miss payments or outright fail to repay the loan. In that case, the lender will recoup the amount it lent you (plus possible penalties) by seizing funds from your savings account, and it will also report your delinquency to the credit bureaus, leading to negative entries in your credit report that can cause lasting harm to your credit scores.
A credit-builder loan is a great vehicle for beefing up your credit history, and it serves as a stealth savings tool as well. Paying one off early is always an option in an emergency, but it's one you should probably avoid if at all possible.
