How Cash Secured Loans Work

Got Cash? Build Credit

Handshake upon loan approval at bank
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If you need to improve your credit while protecting your savings, a cash secured loan might help you accomplish your goals. The concept sounds strange at first: Borrow against your savings in the bank — and pay more interest on the loan than you’re earning on savings. But there benefits to using your cash to secure a loan. Those loans are especially helpful for building strong credit, and they can also help you manage your behavior.

What is a Cash Secured Loan?

A cash secured loan is a loan that you guarantee by depositing funds with your lender. You “qualify for” the loan primarily based on the lender’s ability to take the cash if you stop making payments on the loan.

To use this type of loan, you’ll borrow from the same bank or credit union where you have money in a savings account, money market account, or certificate of deposit (CD).

Because you already have the money available in your account, there is minimal risk to the lender. You’ll pledge that cash as collateral, meaning the lender can take possession of the funds if you fail to repay the loan as agreed. As a result, it will be easier to get approved. If you can’t qualify for other types of loans (such as unsecured loans or credit cards), cash secured loans might be a good idea.

How they Work

Use for anything: Cash secured loans can be used for any legal purpose.

But it’s best to put the money towards something that you really need or that will bring a return on your investment (such as improvements to your home). The loan can come in the form of a lump sum, or you can use a line of credit (with a cash secured credit card, for example).

Competitive rates: You pay interest even though your lender already has the cash to guarantee the loan.

However, the interest rate you pay on a cash secured loan is lower than what you’ll pay for most other loans. Unless you have high credit scores, you’ll get a better rate with these loans than with credit cards or personal unsecured loans. Again, the risk to your lender is small, so the cost to you is lower.

Fixed rates: Interest rates are typically fixed on loans that you take in a lump sum, so your payment remains the same over time. You don’t take the same risks that come with a variable rate, such as surprise payment increases. Especially if rates are low, getting a fixed rate for several years can work in your favor if your savings start to earn more. If you use a cash secured credit card, the rate will be ​variable.

How much? Some banks let you borrow the full amount that you’ve deposited and pledged as collateral. Others limit the loan to value ratio to around 90 percent (or less). For example, for every $100 in your account, they might only allow you to borrow $90. If your primary goal is to build credit, you don’t need a huge loan — several thousand dollars is plenty, and it’s common to start with loans that are smaller than that. Some banks offer cash secured loans for up to $100,000 — the maximum amount depends on your bank or credit union.

Short terms: Most cash secured loans come with relatively short terms. Ten years or less is common. These loans are best for helping you through tough times and improving your credit scores. If you’re looking for a 30-year mortgage, a cash secured loan is probably not the right tool.

Installment payments: To repay lump sum loans, you’ll usually make equal monthly payments over the term of your loan. A portion of each payment reduces your loan balance, and the remainder is your interest cost. To see how that process works, read about amortization. Look at some numbers for yourself and plan out your loan.

However, there are variations on the standard loan. Some loans are available in the form of secured credit cards or other types of lines of credit.

Relatively small: 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 will be less burdensome on your finances. You don’t want to lock up any more money than you have to, and you can keep interest costs low.

Why Not Spend Your Own Money?

You might wonder if there’s any point in getting a loan when you’ve already got the cash available. In some cases, spending the cash is a fine option: You’ll avoid paying interest, you keep your debt burden small, and you don’t risk any damage to your credit if you stop making payments.

However, using these loans can be helpful.

Build credit: If you’ve got bad credit (or you’ve never borrowed in the past so your credit is “thin”), these loans can be a stepping stone towards higher credit scores. Every time you successfully pay off a loan, your credit improves (assuming the loan is reported to the credit reporting agencies).

Offset interest costs: If you’re going to pay interest to build credit, it’s beneficial to make up for some of those costs. Of course, you should only borrow and pay interest if you’re getting other benefits. When you use your cash as collateral, the money gets locked up until the loan has been repaid (you might be able to access some of it after you’ve partially repaid the loan). In the meantime, your money continues to earn interest, but you’ll earn less interest than you pay on the loan.

Keep savings intact: There’s also a behavioral benefit. If you have a hard time saving money, it might not be a good idea to blow out your emergency savings (because then you’ll need the discipline to rebuild, and you’ll have to start from zero). Borrowing against your money provides a structure that encourages you to make the required payments, and discourages you from using credit cards to pay for emergencies. Once the loan is paid off, you’ll still have a sum of cash available for future needs.

Better loans in the future: Ultimately, the difference between what you earn and what you pay is the price of improved credit and the psychological benefit. If you use bigger loans in the future (to buy a house or car, for example) the strategy can pay off. If you’ve got better credit and more cash available for a large down payment (because you’ve kept your savings intact), you may qualify for a better rate on those large loans. That rate can result in significantly lower lifetime interest costs.

Tips for Building Credit

If your main goal is to rebuild credit, make sure the loan will actually work in your favor.

  1. Ensure that your lender reports payments to the credit bureaus, otherwise there will be no effect on your credit scores.
  2. Verify that the loan is actually reported by checking your credit periodically (it’s free for U.S. consumers).
  3. Get your payments in on-time — late payments will harm your credit, leaving you with more work to do later.