How Do Credit Builder Loans Work In Canada?

A credit builder loan is a unique financial product that helps you build your credit score. Instead of taking out a loan to get a car or a student loan, a credit builder loan is more like a forced savings account.

As you make small monthly payments to your lender, they report them to a credit bureau. If you make your payments on time, you should see your credit score improve over time. At the end of the loan term, you’ll get all the money you paid returned to you. We’ll get into more of the details so you can decide if a credit builder loan is right for your financial situation.

How does a credit builder loan 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 you to have a minimum credit score or an established credit history.

Here’s how the credit builder loan process works:

1. Application and approval: Choose a loan program through a bank, credit union, or other lender (like KOHO or Borrowell) and read through the loan’s terms and conditions. To apply, provide your personal and financial information.
2. Make regular, timely payments: 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.
3. Monitor your credit score and report: Check your score regularly to see if there are errors or any improvement. Your lender reports your payments to at least one of the credit bureaus. If you’re late with payments or miss them altogether, that gets reported too.
4. Completion: 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 or subscription fees you paid.

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.

How credit builder loans may affect your credit history

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 three to six months.

Just be aware that if you’re late with payments or miss payments, the credit builder loan could actually damage your score – all the more reason to be diligent with your payments.

Pros and cons of credit builder loans

There are several significant benefits to a credit builder loan, but some drawbacks to consider, too.

Pros:

• 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 a 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.
• Improved 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.
• Easy to qualify for: Unlike credit cards or personal loans, it’s fairly easy to apply for and open a credit builder loan. This is because you’re the one making payments up front instead of borrowing money and paying it back.

Cons:

• 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 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.
• Takes time to see results: Another factor that goes into calculating your credit score is how long you’ve had your credit accounts open. It often takes at least three to six months to start seeing a difference in your credit score, and up to a year to see a significant improvement.
• Requires significant self-discipline: Credit builder loans can be difficult to stick with since you’re basically paying a small loan without receiving anything upfront. You’ll have to stay the course and continue making deposits to see your score improve. Remember, you’ll get all of the funds you deposited back at the end of the loan term (minus any fees or interest).

Who should use a credit builder loan?

Credit builder loans are a good option for people who have no credit history and need to establish one to qualify for other loans, or for people who want to improve 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 – though you could get a student credit card instead.

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

FAQ

What is a credit builder loan?

A credit builder loan is a program designed to help you build your credit score. You make small, regular payments to the lender and they report them to the credit bureaus. Over time, if you make payments on time, your credit score will improve.

Do credit builder loans give you real money?

Unlike personal loans, credit builder loans don’t actually give you money or an item (like a new car). You’re the one making payments, which you’ll get back when the term of the loan is up.

Do you get your money back from a credit builder loan?

Yes! Think of a credit builder loan as a forced savings account. You’ll get all of that money back at the end of the program, when, hopefully, your credit score has improved. Keep in mind that these programs can charge administrative or interest fees, so you might have slightly less money at the end of the loan.

What are the pros and cons of a credit builder loan?

Benefits include the fact that they’re easy to qualify for, they cost very little, and they can build your score. The biggest potential drawback is that you can harm your score if you’re late or miss payments.

Can I pay off a credit builder loan early?

You shouldn’t pay off a credit builder loan early because the goal is to make regular payments over several months in order to create a positive credit history. Paying it off early defeats this purpose.