How Do Credit Builder Loans Work In Canada?

With a credit builder loan, you sign up with a lender and pay a set monthly amount, which is deposited and held in an account. The lender reports your monthly payments (or late/missed payments) to at least one of Canada’s 2 credit bureaus, Equifax and/or TransUnion. When you finish "paying off" your credit builder loan, the money you paid (minus any fees and interest) is returned to you.

In Canada, credit builder loans are offered by some banks, credit unions, and online lenders. Depending on the lender, each credit building program may work a bit differently. For example, KOHO’s flexible credit building program lets you deposit your own money as a line of credit, withdraw it as needed, and repay it at the end of the month.

Having a good credit score makes it easier to qualify for all financial products, including credit cards, personal loans, car loans, and mortgages – and get the best interest rates. But it can be hard to get there if you have a bad credit history or no credit history, which is where a credit builder loan can come in handy.

How do credit builder loans work?

It’s easier to qualify for a credit builder loan compared to other types of credit, such as credit cards, car loans, or lines of credit, as these may require a minimum credit score or established credit history. If you use a credit builder loan successfully by consistently making on-time payments, you may improve your credit score enough to qualify for a credit card or regular loan.

Here’s how the credit builder loan process works:

Step 1: Read through all the details

Before signing up for any type of loan, make sure you understand all the terms, including the total loan amount, interest rate, any other fees, monthly payment amount, and payment schedule (weekly, biweekly, or monthly). You should also check to see if there’s a charge for paying off the loan early.

Step 2: The approval process

Just like a regular loan, you’ll need to apply for a credit builder loan through a bank, credit union, or other lender either online or in person. Each lender has its own application process and eligibility criteria, but generally, you’ll need to provide personal and financial information. This can include things like your income and a government-issued piece of ID to prove your identity.

Step 3: Make your payments on time

You are responsible for making payments on time each month until the loan is paid off in full. For example, a credit builder loan may require you to make monthly payments of $25 for 20 months to pay off a $500 loan.

Step 4: Monitor your credit score and history

As you make payments on your loan, the lender will report to the credit bureaus, TransUnion and/or Equifax. But if you make late payments or stop paying altogether, that gets reported too. As long as you continually make on-time payments over the life of your loan, you should start to see your credit score improve.

Once the loan is paid back and the loan term ends, your money will be returned to you, minus the interest portion of your payments and any administrative fees you paid.

Benefits of credit builder loans

There are several significant benefits to a credit builder loan. Here are a few of the most important ones:

• Building or rebuilding credit: If you don’t have any type of credit history, a credit builder loan is a good way to establish one. Even if you choose a modest loan amount with smaller monthly payments (for example, $20 a month), you’ll still get the benefit of on-time payments reported to the credit bureaus, which will help improve your credit score. Establishing positive payment history shows lenders you can be trusted to borrow money and pay it back.
• Saving money: Credit builder loans have the benefit of forcing you to save money. Remember, you won’t get your money back until the loan is paid off (depending on the lender’s terms), but your money is held safely for you in an account.
• Improving credit mix: Your credit score is also based on having different types of credit accounts, such as credit cards, a line of credit, or a mortgage, so lenders can see that you can handle repaying different types of debt over time. If you already have other types of credit accounts, a credit builder loan can add to that mix.

Drawbacks of Credit Builder Loans

Of course, no financial product is perfect and credit builder loans have downsides too. If you're curious about what you should be wary of, here are a some details to consider:

• Higher interest rates and fees: Some credit builder loans may have higher interest rates compared to other types of loans – as high as 10% to 30%. Some lenders may also charge additional processing fees, administrative fees, or late fees.
• Risk of default and negative impact on credit: If you make a late payment or miss any payments, that’s reported to the credit bureaus too, which could negatively affect your credit score. If your credit score is low because you have a history of struggling to keep up with repayments, make sure you can afford to commit to the terms of a credit builder loan.
• Limited loan amounts: Compared to other loans, credit builder loans are usually only available in smaller amounts, from a couple hundred dollars to a few thousand. This type of loan also has shorter terms, usually from 6 months to 24 months.
• Lengthy credit building process: Another factor that goes into calculating your credit score is how long you’ve had your credit accounts open. It takes at least 3 to 6 months to start seeing a difference in your credit score, and up to a year to see a significant improvement.

Who should consider credit builder loans?

Credit builder loans are an option for people who have no credit history and need to establish one to qualify for other loans, or for people who want to increase a low credit score.

If you don’t have any kind of credit history because you’re a student, have never opened any kind of credit product, or are new to Canada, a credit builder loan could be the first step in establishing a credit profile.

If you have a low credit score because of things like missing payments, defaulting on a loan, or declaring bankruptcy, a credit builder loan is an option that can help rebuild your credit for a manageable monthly payment – without giving you more money to spend.

Tips for maximizing the benefits of credit builder loans

If you do decide to apply for a credit builder loan and want to make the most of it, there are a few tips you can follow. It will take dedication, but keeping these tips in mind can certainly make achieving your desired results a bit easier:

• Make timely payments: Making consistent, on-time payments is the number one way to build a positive credit history and improve or maintain a high credit score. Make sure to choose a credit builder loan with affordable monthly payments, and stay on top of any other debt or bill payments you have on your plate.
• Manage your credit utilization rate: In general, it’s best to keep your debt levels under 30% of your available credit limit. If you take on a credit builder loan to improve a low credit score but you also have other debts to pay off, make sure you’re making repayments and aren’t racking up more debt.
• Avoid applying for multiple loans or credit cards: Taking out a loan and making on-time payments is one way to contribute to building a positive credit history, but applying for too many new credit accounts within a short period of time will lower your credit score.

How long does it take to see credit score improvement?

There's no doubt that you'll be anxious to see an improvement to your credit score, but how soon this will be noticeable depends on whether you have no previous credit history, or if you’re trying to improve a low credit score due to things like missed payments or defaults. It’s easier to build a positive credit history from scratch than to correct past mistakes on an existing poor credit profile.

It also depends on how often the lender reports your payments to the credit bureaus and what other debt repayment obligations you have, but you should see incremental improvement within 3 to 6 months.

Is a credit builder loan right for you?

Before signing up for a credit builder loan, make sure to compare options from different lenders and educate yourself about the loan’s terms, interest rate, and fees. You need to know how much you’ll actually be paying over the life of the loan. Also, following a basic credit building program can help you improve your credit score so you can qualify for other loans later.

Will you apply for a credit builder loan? Did we leave out any information that you're curious about? Feel free to leave us a note in the comments section below.

This is a guest post from KOHO, a fintech company that gives Canadians unique ways to keep track of their money.