Passbook Savings Loans are Secured by Savings, CD Balances

Borrowing against your own cash and paying interest on that loan might seem counterintuitive, but savings account customers across the country are doing just that.

Why? It's an option if you're looking to build or rebuild your credit history, or you want to borrow money at an extremely low interest rate rather than draining your savings or cashing in a CD.

Credit unions and banks of all sizes offer their customers "passbook savings loans" -- named after the savings account booklets used to log withdrawals and deposits. Some banks refer to the loans as secured personal loans, savings secured loans, collateral loans or other names. They are particularly common at smaller financial institutions.

All have the same basic setup: You borrow money using your own savings account or certificate of deposit as collateral, while paying a much lower interest rate than you would on a credit card or unsecured personal loan.

"They are another option for consumers to begin to repair their credit or finance an event or project at a very competitive interest rate," says Todd Denbo, a senior vice president within the personal credit management group at Wells Fargo, headquartered in San Francisco. He says passbook loans are growing in popularity, but aren't as popular as unsecured personal loans.

Three types of borrowers

Those who are interested in passbook loans tend to fall into three categories. One group is comprised of people without credit histories credit histories, including young adults who can't get their hands on a traditional credit card. The loans are also "a great tool for people who are new to the country to build a credit profile," Denbo says.

The loans also can appeal to a second group -- the millions of Americans who have tarnished credit, or are coming out of bankruptcy. These borrowers have a tough time getting approved for new credit, or accessing credit at reasonable rates.

The third group is those who "may not want to liquidate their savings or CD and are looking for a low rate to borrow (money at)," he says. These consumers may be afraid they won't be able to replenish their savings, or "just psychologically may not want to touch it."

Passbook loan rates vary greatly (see chart, "Compare passbook savings and CD loans"), but can be as low as 2% above what the savings account or CD earns, and these days many savings accounts are earning less than 1% APY.

Even though you're using money from your account to collateralize your loan, you continue to earn interest on your savings account or CD.

In some cases, you can borrow up to 100% of the amount of money in your account, or it may be a lesser amount. Since the account serves as collateral for the loan, for example, if you have $20,000 in your account and borrow the full amount, you can't withdraw any money from your account until you've paid back at least part of your loan.

If you pay back $1,000, you can then withdraw that $1,000 from your account. The amount in the account must equal or exceed the amount you owe.

Borrowing against your CD can be a good choice if you bought it several years ago, when rates were high, and only need extra cash for a few months, says Dorothy Barrick, group manager and financial counselor at GreenPath Debt Solutions, based in Troy, Mich.

By borrowing against a CD rather than cashing it in, you avoid early withdrawal penalties.

At the same time, "if someone has money on deposit, a secured loan rate is much better than for someone who uses a different product," says Tony Gallardy, vice president of consumer/credit card lending at Navy Federal Credit Union, headquartered in Vienna, Va.

In the first quarter of 2012, the average rate for a 24-month unsecured personal loan at a commercial bank was 10.88%, according to the Federal Reserve. The average rate on a credit card was 12.34%.

Secured loans have very low rates because they pose very little risk for lenders, Gallardy says.

Even if you don't have big bucks in the bank, simply having a small savings account can usually get you a secured loan.

If your goal is to build or rebuild your credit history, secured loans generally involve much smaller sums of money than others types of loans. So someone might put $500 in a savings account and then borrow $500 against it.

For a person who has been through bankruptcy, "it allows them to regrow their credit score," Barrick says.

Not all lenders report payment data to credit bureaus

Experts say it's crucial to make sure the bank or credit union reports your payments to one of the major credit bureaus (such as Experian, TransUnion or Equifax). Barrick says larger financial institutions routinely report these payments, but small banks and credit unions might not do so.

If someone is establishing or re-establishing credit, an issue may be "having to come up with the money" to open an account and then "knowing they can't touch it," Barrick says.

If you're trying to build or boost your credit score, another option is a secured credit card.

These are similar to secured personal loans, where a sum of money, such as $500, is deposited into an account, which serves as collateral for the credit card. Secured credit cards typically charge annual and other fees. Gallardy says his college-age daughter opted for a secured credit card because she earns points when she makes purchases, which she can use to buy merchandise and gift cards.

"It's a great tool to learn to use credit," he says. After a year's success with a secured credit card, someone like Gallardy's daughter might be able to switch to a regular, unsecured credit card.

Barrick counsels those with a secured credit card to make limited purchases, such as charging their gasoline each month, and then paying it off in full to avoid interest charges.

If you fail to pay back a loan or make payments on a secured credit card, the financial institution can seize the money in your account to cover the outstanding balance. Gallardy says a secured loan can fit the spending goals of consumers who are "more aware of the dangers of carrying too much debt and are living more within their means."