Credit-builder loans help solve the most frustrating problem you face when trying to improve your credit.

Because lending involves risk, lenders are more inclined to lend money — and to offer better terms — to people who have good credit. This is because good credit signals that someone is more likely to pay back a loan. But you can’t build good credit unless a lender gives you a chance to prove you are worthy. This makes sense from a lender’s perspective — they don’t want to take a chance on a borrower whose riskiness is unknown. But it’s really frustrating if you’re trying to borrow and no lender wants to be the first to do business with you.

Fortunately, there are ways lenders can provide you a loan without taking a risk that you won’t pay it back. One such way is with a credit-builder loan.

“Credit-builder loans offer a solution to the daunting challenge of raising your credit score — if done the right way,” advised Sacha Ferrandi, founder and principal of Source Capital Funding, an equity-based lender.

With a credit-builder loan, a lender doesn’t actually give you access to money you’ve agreed to borrow until you’ve paid for the loan in full. Since they control the funds, and therefore don’t risk anything, lenders that offer credit-builder loans are more willing to give them to borrowers with poor or no credit. Once you’ve got the loan, the lender reports on your payment history to credit-reporting agencies. This helps you build credit, because you’re creating a history of on-time loan payments.

How does a credit-builder loan work?

Credit-builder loans are typically offered by small financial institutions, such as credit unions and community banks.

When you get a credit-builder loan, the money you agree to borrow is deposited into a bank account held by the lender. You’ll then make monthly principal and interest payments — which are reported to credit bureaus — for a term usually around six to 24 months. When the loan is paid off, you get the money from the account.

The benefits of a credit-builder loan are twofold: You’re building a little nest egg while also building credit.

Will a credit-builder loan really improve your credit scores?

Whether credit-builder loans improve your credit depends on you.

Lenders report payments on these loans to credit bureaus. If you make your payments on time, this builds positive payment history, which, for example, accounts for 35% of your FICO credit scores. But if you’re late making a payment, that’ll be reported, too. And when you don’t have much of a credit history, a single late payment can be a big setback.

The drop in your scores depends on where you started and your current credit — but myFICO reports that your FICO scores could fall as much as 60 to 110 points. That’s a lot when you consider that the FICO scores range is 300 to 850.

How can you get a credit-builder loan?

To obtain a credit-builder loan, you’ll need to …

• Find a financial institution offering one. In addition to local banks and credit unions, some online lenders offer credit-builder loans. Confirm the lender will report payments to the three major consumer credit bureaus.
• Decide how much to borrow. The typical loan amount is between $300 and $1,000.
• Comparison shop among different lenders. There might be big variations in interest charged, monthly payment amounts, fees, repayment periods and loan origination costs.
• Apply for a loan. You’ll need to provide basic information, such as your name and address. But unlike with most loans, having bad credit when applying won’t disqualify you.

Once you’re approved and your loan is granted, you’ll make payments until the loan is repaid in full, after which the funds are then distributed to you.

How much does a credit-builder loan cost?

Costs of a credit-builder loan vary depending on the lender. When looking for your loan, pay attention to …

• The APR: APR, or annual percentage rate, is the amount your lender charges you to borrow the funds. An APR of less than 10% is common with credit-builder loans, but some have higher rates.
• Interest payments: Lenders offering credit-builder loans may keep some or all the interest you pay, giving you only the remaining balance at the end of the loan term.
• Other fees and costs: Lenders may charge an application fee for the loan or charge late fees if you don’t pay on time.
• The loan repayment term: The longer your loan term, the more interest you’ll pay.
• Maximum and minimum loan limits: You don’t want to borrow too much or too little. If you borrow a larger amount of money it could take you longer to pay back, which means paying more in interest.

Finding a lender that offers favorable terms ensures you’ll be able to use a credit-builder loan to boost your credit without spending a fortune.

Bottom line

A credit-builder loan can be a great tool to build credit from scratch or improve low credit scores. Just make sure to find the right lender and understand the loan terms — and of course, never make a payment late or you’ll undermine your credit-improvement efforts.