If you’ve never had any credit before, or are recovering from bad credit, consider taking out a credit builder loan. This type of loan is specifically designed for people who may not qualify for traditional financing, such as a credit card or personal loan.

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There are a few restrictions, but they can be an easy way to build credit history without a credit card. No matter what type of financial background you have, a credit builder loan could be the solution you’re looking for.

Keep reading to find out how they can help build credit and how you can qualify for one.

What is a credit builder loan?

Also known as a “starting over loan” or a “fresh start loan,” a credit builder loan helps you build credit while borrowing cash.

It’s similar to a secured credit card, except you don’t need money up front to act as a security deposit. Instead, you receive the loan amount, but you must repay the loan and interest in full before you can actually access the cash.

It’s a safe transaction for both of you because you don’t risk ruining your credit any further and the bank doesn’t lose any money if you don’t repay the loan. Plus, your on-time payments are reported to the credit bureaus, helping to improve your credit score over time.

Because credit builder loans typically have that holding period where you can’t access your funds right away, it’s not a great choice for a financial emergency that requires immediate cash.

However, if you know you need to save up for a major purchase and want to build credit, then it could be an excellent choice for you. A credit builder loan isn’t an overnight solution to your financial or credit problems, but it can help you out in the long run.

With a better credit history, you’ll be able to get lower rates on larger loans or credit cards in the future. By making interest payments on a small amount now, you can save money in the long run when you need to borrow money for a larger purchase.

See also: How to Rebuild Your Credit Using Secured Credit Cards

How do credit builder loans work?

When talking about loans of any kind, you can categorize them by being either secured or unsecured. A secured loan is backed by some type of collateral you provide to the bank. For example, a mortgage uses your house as collateral, while an auto loan uses your vehicle as collateral. For a credit builder loan, the bank uses the money you pay upfront as collateral on your secured loan.

A hybrid option allows you to have some of the funds released as the loan is paid off. Typically, you would use an existing savings account as collateral, so this would still be considered a secured loan.

Your interest rate (or annual percentage rate) will be lower if your loan is secured, so you save money. However, you’re not able to access all of the funds right away because of the freeze period, which can be troublesome if you need cash now.

Another option is to get one that is unsecured. This is less common and comes with both pros and cons. For example, you can expect to pay a much higher interest rate with an unsecured credit builder loan compared to a secure done. On the other hand, you get to access cash right away, so you can use the funds in a financial emergency.

You also don’t have to provide any collateral or even have a bank account prior to signing up for the loan. This lessens your risk of losing your savings or other property in case you default on the loan.

Of course, the increased interest rate covers the lender in case this happens, so you do pay for the convenience of that lesser personal risk. The best choice for you depends on your financial needs and what you qualify for.

Where can I get a credit builder loan?

This type of loan is usually found at smaller financial institutions like a community bank or credit union. This type of loan may not be advertised, so it’s best to call around and ask if they’re available.

Start with a local bank you have an existing account with, as they’ll likely be more willing to help a current customer, especially if you have a good relationship with them. Don’t automatically discount credit unions, because many of them have flexible guidelines for joining.

While some local credit unions may have certain employment requirements, many may just require you to live in a certain area. Many credit unions across the country allow you to become a member by making a low, one-time contribution to a non-profit organization of their choice. It’s a quick and easy way to get access to specialized financial products like a credit builder loan.

You can also compare loan terms from certain online lenders. Self, for example, allows you to take out a loan in increments ranging from $550 to $2,200. The money is held in a CD account and earns interest while you make monthly payments for a year. Read our full review of them here.

Your payment includes both principal and interest on the loan amount. Once you repay the entire loan, you get the money from the CD account, plus the interest that earned over the year.

It won’t be enough to cover the interest you paid for the loan, but it does give you a full year of positive payment history on your credit report. If you don’t finish paying off the loan for some reason, you’ll receive the balance of the money in the account, with your outstanding loan balance subtracted from that amount. Check out other lenders to compare loan amounts and interest rates.

How can you qualify for a credit builder loan?

Qualification standards vary depending on the lender you choose. However, there are a few things you can count on no matter where you go. First of all, you’ll need to be at least 18 years old and have a valid social security number. If you go with a traditional lender like a credit union or bank, you may need some type of account with them.

If you choose a credit union, you’ll have to join based on their individual membership guidelines. Otherwise, you’ll likely just need some type of banking account or debit card for the bank to reference.

If you’re using an online lender rather than a local credit union, make sure they’re licensed to make loans in your state. A few states have strict lending laws that may prohibit certain credit builder loans. But, most states do allow them.

While a strong credit score or credit history obviously aren’t required to qualify, many lenders do have other credit-related requirements. For example, they may not allow you to have had any entries in ChexSystems within the last six months. This refers to any type of unsavory past with a bank or credit union, such as excessive overdraft fees, check fraud, or unpaid fees.

If you’ve never had a problem with ChexSystems, then you should be just fine. If you have, you may need to wait a while before your ChexSystems report ages a bit more. Check with your local loan officer or online with your lender to find out any other requirements. Most approval processes are quick and easy, taking just minutes when you apply online.

How do credit builder loans affect your credit?

As long as you make your payments on time each month, they can improve your credit score. Or create one if you don’t have a history built yet.

Timely payments are the most important component of your credit score because it represents 35% of that number. Paying bills on time, especially those from creditors that report to the credit bureaus each month, are the best way to consistently build your credit over time.

On the other hand, they can also hurt your credit if you have any late payments. Depending on your credit score to begin with, a single late payment can cause a huge drop. That’s why it’s so important to make sure you can afford your monthly payments, otherwise, you’re setting yourself up for failure.

If you don’t have any credit built at all, a credit builder loan gives you an actual credit history. In addition to a solid credit score, lenders also want to see that you have a history of making credit payments on time. If you have nothing but on-time payments listed on your credit report, then a lender or creditor will assume that you are capable of making payments each month.

You can expect to start seeing payment entries on your credit report within a month or two of paying your loan. A credit builder is also a fairly quick way to increase your score; in fact, you can establish your credit score within about six months if you’re starting from scratch. Those kinds of results can definitely make the interest rate worth it.

What should you consider before taking out a credit builder loan?

There are some things to consider before you take out a credit builder loan. First, remember that this is not a quick-cash solution. If you need money immediately, find a different financial product. Next, consider how much money you want to borrow.

Most credit builder loans have maximum amounts between $500 and $2,500. You may be able to borrow a little bit more, but that’s the general range. The exact amounts vary depending on your where you get the loan and where you live. Loan terms generally last between 12 and 24 months.

Make sure your financial situation and career are both stable enough to take care of those payments for the duration of the loan. It’s also good to have a backup plan in case something unexpected comes up. You just never know when an illness or job loss could hit you or a loved one.

Another consideration is that your payments will be lower with a longer payment term, but you may end up paying more in interest over time. It’s up to you to determine which situation works better for you. Also, compare interest rates to other loans.

Depending on your credit and other information, you could pay extremely high rates. They may be more than credit cards and could even be comparable to payday loans. This may not always be the case, but it’s important to be aware of just how much a credit builder loan will cost you over time.

Finally, whatever credit builder loan you choose, make sure the lender actually reports to all three credit bureaus. If they don’t, there’s simply no reason to take out the loan. Make sure it truly works for you by establishing a lasting credit history you can leverage in the future.