Trying to establish credit from square one can be challenging. Before extending credit, creditors want to see that you can manage it responsibly. But if you haven’t had credit before, there’s very little information on which they can make that decision. Fortunately, there are a few financial tools that can put you on the path to establishing a credit history. One of them is a credit builder loan. Let’s see how they work.

What is a Credit Builder Loan?

The purpose of these loans is right in the name. They are personal loans designed to help people establish a credit history and demonstrate an ability to pay back money they borrow. These loans tend to fly under the radar, so you might have to ask your bank about them. In many cases, smaller, community banks, credit unions or licensed online lenders are more likely to offer credit builder loans than larger banks, but it never hurts to ask.

How do These Loans Work?

If you are approved for a credit builder loan, the amount you borrow is held in a bank account while you make regular monthly payments of a set amount. You generally won’t be able to access these funds until the loan is paid in full. The creditor will report your payment history to at least one of the three major credit bureaus, allowing you to start building a credit history. As with all financial products, be sure to shop around to find an interest rate and repayment terms that fit your budget.

What are the Pros and Cons?

Credit builder loans can be an effective financial tool for consumers who are new to using credit or those who are trying to rebuild their credit following financial challenges. Because you won’t have access to the funds until you’ve paid off the loan, you’re building savings as you’re building your credit. The downside of a credit builder loan is that if you fall behind on payments, you risk harming your credit more than helping it. That’s why it’s important to find a monthly payment that fits with your current budget and make every payment, on time, no exceptions.

Are There Other Ways to Build Credit?

If you can’t find a credit builder loan that meets your needs, there are other things you can do to build credit. A secured credit card works similar to one of these loans. You build up a lump sum in a savings account and the credit card’s limit matches the balance in the account. If you’re unable to make payments, the lender uses what you have in savings to cover it.

Another way to build credit is to become an authorized user on someone else’s credit card. That credit card company reports to the credit bureau in both your names and allows you to add to your credit history. Finally, a store credit card can be an effective way to build credit if you use it carefully. Ideally, you’ll want to make one or two small purchases each month, then pay them off in full to show you can manage credit effectively.