Your credit score is among the main factors that help you qualify for credit and set your rates. If that number is below the good credit threshold, you might be stuck with high interest rates and expensive monthly payments.

One way to address this issue is a personal loan to improve your credit. These loans are designed specifically for borrowers who want to raise their scores. However, they come with the same risks as any type of loan. Consider the benefits and drawbacks before applying.

What is a credit builder loan?

A credit-builder loan is a financial tool designed to help people build or improve their credit. Credit-builder loans work differently than most loans. Instead of receiving money right away, the funds you borrow are kept in an account until you repay your loan. Once the loan is repaid, you receive your money — minus any fees the lender charges.

Each payment you make on your credit-builder loan is reported to at least one of the credit bureaus. This establishes a positive payment history, building or improving your credit. You’ll need to check with your lender to see which bureaus it reports payments to.

Pros of credit-builder loans

A credit-builder loan is a way to show the major credit bureaus you can consistently make on-time payments. Doing so should improve your access to other financial products. Consider the advantages of credit-builder loans before you apply.

Can improve your credit

Most notably, credit-builder loans can improve your credit score. As you pay each month, those on-time payments are reported to credit bureaus. Payment history accounts for up to 35 percent of your score, and as that track record improves, your credit score likely will too.

Flexible acceptance

Credit-builder loans are designed for those with little credit, no credit or poor credit, so their eligibility requirements are much more flexible. Dara Duguay, CEO of Credit Builder Alliance, explains: “These loans are less risky for the lender since they hold the money until the customer has made all their required monthly payments.” That allows lenders to lower their eligibility requirements.

While lenders will not require good credit, they will request information about your income, employment history and bank account balances to ensure you can afford your payments.

Ability to build savings

Typically, when you take out a loan, you are borrowing money to pay for a significant expense. In this case, the lender holds onto the money and sends it to you once you’ve paid it off, minus any fees. You’re essentially saving money for later. Some lenders even put your money in a certificate of deposit account where it will earn interest, though it may not be enough to offset the annual percentage rate (APR) the lender charges.

Cons of credit-builder loans

Although credit-builder loans have upsides, all financial products come with their share of risks. Consider the downsides of credit-builder loans before you choose one over alternatives like secured credit cards.

Potential to drop credit score

As with any loan, a credit-builder loan can lower your credit score if you miss payments. Missed payments can be reported to the credit bureaus and could remain on your credit report for up to seven years. You may also be charged late payment penalties or forfeit your money.

Lenders can charge high fees

Interest rates and standard fees vary significantly among lenders. Some offer zero interest or fees and some may partially refund the interest when you pay off the loan. Others enforce steep fees that can significantly increase your expected monthly or overall cost. Common fees include prepayment penalties, origination or administrative fees and processing fees.

According to Duguay, more and more nonprofit lenders and credit unions are offering small-dollar credit-builder loans. Ask lenders for a list of their fees before applying. It’s worth comparing your options to save money and ensure you get fair terms if you decide a credit-builder loan is right for you.

No immediate access to money

Credit-builder loans can have repayment terms of up to 24 months, and your money will not be accessible during that time. If you need fast cash for an urgent situation, explore emergency loans instead.

Are credit-builder loans worth it?

While credit-builder loans are different from other types of personal loans that provide a line of credit or lump sum of cash, they can be well worth it for consumers who need help building credit.

Monique White, former head of community at Self Financial, says these loans are best for consumers who are new to credit or someone who has been denied access to traditional financial products in the past.

“Credit can be a catch-22 because typically you need credit to build credit,” White says. “A credit-builder loan can open the door for someone to access credit by building positive credit history over time and gaining access to other credit products.”

While credit-building alternatives give borrowers a line of credit they can spend, credit-builder loans actually help consumers save. Unlike a typical loan where you receive the funds upfront, with a credit builder loan the funds are held in a CD and the consumer pays in monthly installments.

“Each payment is reported to the credit bureaus and builds credit history,” White explains. “At the end of [the] term, the consumer can access the savings, minus interest and fees.”

At the end of the day, that makes credit-builder loans a form of “forced savings” that helps consumers build credit history along the way.

Bottom line

Taking out a credit-builder loan can be a great option for some borrowers, but they are not ideal for everyone. While they are an option for those with little history, these types of loans do not provide immediate access to funds, and they may come with high fees.

If your main priority is to improve your score, and you feel confident in your ability to pay off the loan, a credit-builder loan can be step one to achieving excellent credit. Be sure to learn how to choose a credit-builder loan before jumping into any financial commitment.