How Cash-Secured Loans Work
Building credit can be hard when you’re just getting started or recovering from financial difficulties. But a cash-secured loan might help you qualify for a loan that helps you improve your credit. At the same time, you preserve cash in an account that you can use later. The concept may sound unusual because you borrow against your savings in the bank, but these loans can be a win-win for everybody.
Be aware that the loan will probably cost more in interest charges than the money you’re earning in interest on your savings. But with small dollar amounts, the benefits over your lifetime can outweigh the costs.
What Is a Cash-Secured Loan?
A cash-secured loan is a credit-building loan that you qualify for with funds you keep with your lender. Because the lender already has enough money to pay off your loan, lenders may be willing to approve you for the loan. If you stop making payments on the loan, the lender keeps your deposit (or a portion of it) to pay off your debt.
To use this type of loan, you borrow from the same bank or credit union where you keep your money in a savings account, money market account, or certificate of deposit (CD). You can inquire about cash-secured loans at your current bank, or open an account at a new institution.
Since you already have the money available in your savings account, the lender assumes minimal risk by approving your loan. Your spending limit should be no higher than the amount of cash in your account. The lender requires you to pledge your cash savings as collateral, meaning that the lender can take your savings if you fail to repay the loan as agreed.
If you can’t qualify for other types of loans, such as unsecured loans or credit cards, cash-secured loans might provide an alternative for improving your credit. They are also useful for young people trying to build their credit from scratch.
How This Financing Works
Use for Anything
You can use the funds from cash-secured loans for any legal purpose. You might put the money toward something that you really need, or something that will bring a return on your investment, such as home improvements. The loan can come in the form of a lump sum deposit to your checking account, or you might receive a line of credit with a cash-secured credit card.
You still pay interest even though your lender already has assets to guarantee the loan. However, you benefit from a lower interest rate on a cash-secured loan than what you’d pay for most other loans.
If your credit scores are low, you should expect a better rate with these loans than with credit cards or unsecured personal loans. Because you've secured the loan with your own savings, the lender takes a smaller risk. This is reflected in lower costs for you.
Cash-secured loans that you take in a lump sum often have fixed interest rates, so your payment remains the same over time. You don’t face the same risks that come with a variable rate, such as surprise payment increases. If you can get a low rate, keeping that fixed rate for several years can work in your favor if your savings start to earn more or interest rates rise on other loan alternatives. If you use a cash-secured credit card, the rate will likely be variable.
Some banks let you borrow the full amount you deposit and pledge as collateral. Others limit the loan-to-value ratio to around 90% or less. For example, for every $100 in your account, the lender might allow you to borrow $90.
If your primary goal is to build credit, you don’t need a massive loan. Several thousand dollars should be plenty, and it’s common to start with loans smaller than that. Some banks offer cash-secured loans for up to $100,000, but the maximum amount depends on your bank or credit union.
Most cash-secured loans come with relatively short repayment terms, such as ten years or less. These loans can best help you through tough times while improving your credit scores.
To repay lump-sum loans, you typically make equal monthly payments throughout the term of your loan. A portion of each payment reduces your loan balance, and the remainder covers your interest cost.
To see how that process works, learn about amortization. Run the numbers for yourself and plan out your loan.
You don’t need to go big to take advantage of these loans. If you’re just starting to build or rebuild credit, ask about borrowing a few hundred dollars. A smaller loan is less burdensome on your finances. You only lock up as much money as you have to, and you can keep interest costs low with a small loan.
Why Not Just Use Your Own Money?
You might wonder why you’d ever bother with a loan when you already have cash available. In some cases, just spending the money makes sense since you’ll avoid paying interest, keep your debt level low, and avoid damage to your credit if you stop making payments.
Still, you can benefit from these loans in several ways:
If you have bad credit or you’ve never borrowed in the past (known as having “thin” credit), these loans can be a stepping stone toward higher credit scores. Every time you successfully pay off a loan, your credit improves—as long as your lender reports the loan to major credit reporting agencies.
Offset Interest Costs
If you choose to pay interest to rebuild your credit through a loan, it’s beneficial to make up for some of those costs by earning interest on your savings. It makes sense, though, to borrow and pay interest only if you’re receiving other benefits.
When you use your cash as collateral, the money gets locked up until you pay off the loan and close your credit account. You might be able to access some of your money after you partially repay the loan, but in the meantime, your money continues to earn interest, although probably less interest than you pay on the loan.
Keep Savings Intact
There’s also a behavioral benefit. If you have difficulty saving money, it might not be a good idea to use up your emergency savings because you’ll need the discipline to rebuild that fund, and you’ll have to start from zero.
Borrowing against your savings provides a structure that encourages you to make the required payments, and discourages you from using credit cards to pay for emergencies. Once you pay the loan off, you still have a sum of cash available for future needs.
Better Loans in the Future
Ultimately, the difference between what you earn on savings and what you pay on the loan should buy you better credit and potential psychological benefits. You may qualify for lower interest rates on significant loans in the future—to buy a house or car, for example.
With improved credit and cash available for a large down payment (because you maintained your savings intact as collateral), you may qualify for better terms on larger loans. Low rates and better options can result in significantly lower lifetime borrowing costs.
Using Loans to Build Credit
If your primary goal is rebuilding your credit, make sure the loan works in your favor:
- Select a lender that reports payments to the credit bureaus. Otherwise, your credit scores won’t change.
- Verify that the payments are actually reported by checking your credit periodically (it’s free for U.S. consumers).
- Always pay promptly, since late payments will damage your credit, leaving you with more “repair” work to do later.