What Is a Credit-Builder Loan?

Building a credit history isn't as simple as securing a conventional loan and paying it off. Sometimes it's difficult for consumers -- like the freshly divorced, recently graduated or newly immigrated -- to have enough of a credit record to obtain a loan or open a credit card.

Credit-builder loans can be an ideal way for someone who has no credit record to start building one. There are about 26 million U.S. adults in this "credit invisible" situation. Credit-builder loans give borrowers -- whether building or rebuilding their credit record -- a chance to show they can make regular payments.

If you use a credit-builder loan successfully, you might be able to improve your credit history and, as a result, your credit score. This could help you qualify for larger loans over longer time periods and obtain unsecured credit cards.

[Read: Best Rewards Credit Cards.]

How Does a Credit-Builder Loan Work?

Credit-builder loans are different from other loans because the financial institution requires that you make payments before you get the full loan amount. This is in contrast to a typical installment loan that gives you the loan funds right away, which you pay back over a period of time.

"You don't have a need for the money; you have a need for a better credit score," says Michael Emancipator, vice president and regulatory counsel for the Independent Community Bankers of America.

At the start of the loan process, the lender will transfer its funds to a locked account, and then you begin making regular payments. Depending on the arrangement, the lender can provide some of the funds after payments start or wait to give the loan to you until after the payments are complete.

"The customer doesn't have access to the money but will make amortized payments over 12 months or whatever period is chosen, along with interest," Emancipator says. "At the end, they can access the money."

Loans are offered in a variety of amounts, payment periods and interest rates:

-- Amounts generally range from about $300 to $1,000.

-- Payment periods are usually from six months to two years.

-- Funds are deposited into your savings account.

"It's a loan with training wheels -- so simple to get, easy to pay back," says John Ulzheimer, president of The Ulzheimer Group and a national credit expert who formerly worked with Equifax and FICO. "Unless you're truly strapped, truly irresponsible, it should work perfectly."

One word of caution: A credit-builder loan is not going to have as much influence on the credit score for the customer rebuilding credit as it would for the first-time borrower. Still, says Jordan van Rijn, former Credit Union National Association senior economist, it can help.

What to Look for in a Credit-Building Loan

Before you get a credit-builder loan, make sure the lender will report your payments to all three credit bureaus -- TransUnion, Equifax and Experian. Since lenders will often consult just one credit bureau while underwriting a loan, it's important to have all three of them covered.

Also, you should make sure you can meet the loan terms, primarily the amount of the monthly payment and the length of the loan. If you are not able to make the payments on time, the benefits you had hoped to get from the credit-builder loan could be lessened or backfire entirely.

What Are the Credit-Builder Loan Requirements?

A lender might offer a credit-builder loan as an option if you are trying to establish credit or if you are trying to rebuild credit after a major problem, like bankruptcy.

Once you get something positive on your credit report, it "changes the way lenders and service providers look at you," Ulzheimer says.

For example, recent college graduates who have yet to obtain credit cards could have a better chance of renting an apartment or getting a mobile phone account thanks to the positive credit history achieved through a credit-builder loan.

There are few credit requirements for this type of loan. You just need to:

-- Show you have a source of income that allows you to make payments of about $50 to $100 each month for the term of the loan.

-- Not have any unresolved financial judgments.

If you do have financial judgments against you, "We would typically advise people to get those paid off first," van Rijn says.

[READ: Best Bad Credit Loans. ]

Where to Get a Credit-Builder Loan

You are most likely to get a credit-builder loan at community banks, credit unions or online lenders.

Credit-builder loans are not a great profit generator, which is why some financial institutions don't offer them. Still, some local banks and credit unions count on these low-risk products to lead customers to more traditional borrowing vehicles such as car loans and mortgages.

"You won't necessarily see customers go into a bank asking for this particular product," Emancipator says. "But it might be brought up by a banker to a customer experiencing financial hardship or who doesn't have a credit score to go into a more traditional product."

There are about 5,300 credit unions across the country, and about one quarter of them offer some sort of credit-builder loan, van Rijn says. In total, almost half of credit union members nationwide have access to the loans. Although you must be a member to get a loan at a credit union, it's fairly simple to become a member. Just look for a nearby location and see what the requirements are, van Rijn says.

Alternatively, you can search for credit-builder loans online to see which lenders offer them. It also might be a lender that has a brick-and-mortar presence somewhere in the U.S. but is transacting loan business online.

[Read: Best Online Banks.]

Other Ways to Build Credit

Taking out a credit-builder loan isn't the only way to build your credit and improve your score. You can also:

-- Open a secured credit card. In contrast to more typical unsecured credit cards, secured cards require you to make a deposit -- which usually becomes your credit line -- before you can use the card. Unlike credit-builder loans, you can get immediate access to funds. Make your payments each month and pay off the entire balance to avoid accruing interest.

-- Become an authorized user. With some credit cards, the primary cardholder can add an authorized user to the account. The primary cardholder is still liable for the debt, but the authorized user can benefit from having a credit card account on his or her credit history. When this strategy is well-managed, it's a good way to build credit.

-- Get help from a co-signer. If you can't get a loan, a co-signer with good to excellent credit may be able to help. A co-signer can assure the lender that someone will make the payments, whether it's you or the co-signer. This is a solution parents might choose if they want to buy a car for a child who is a college student and doesn't have a job yet. Once children start working, they can take over the payments.

-- Join a lending circle. This type of lending arrangement has existed for many years in a variety of cultures, in which people in the group lend money to each other. Participating in a lending circle can help your credit history and score if the organization running the circle reports to the three credit bureaus.

Credit-builder loans can be a good choice for improving your credit history, but there is no guarantee of success. You need to show you're taking credit seriously, and the best way to do that is to make payments on time.

[Read: Best Personal Loans.]