When you take out a cash-secured loan you use your own savings as collateral for the debt. You have to pay interest on these loans, so you might wonder why you would want to pay to borrow money when you already have cash in the bank. While these loans aren't for everyone, they are useful for credit-building.
TL;DR (Too Long; Didn't Read)
A cash-secured loan uses the money in your savings account as collateral.
Using Cash as Collateral
Cash-secured loans are normally tied to certificates of deposit or savings accounts. You have to get the loan from the same bank that holds your CD or savings so that the bank can place a freeze on that account. The freeze prevents you from accessing funds in the account until you have paid off the loan. The loan amount can't exceed the balance held in the account. You continue to earn interest on your savings during the loan term and this helps to offset the interest you pay for the loan.
Understanding the Interest Rate
Banks borrow money from one another and from the Federal Reserve and use this cash to fund loans. Banks pay interest on these borrowed funds and mark up the interest rate before lending this money out to consumers. The interest rate paid by most borrowers is determined by what's known as the prime rate, which is the interest rate an individual bank gives to their most trusted customers.
Banks will add percentage points to the prime rate, depending on a borrower's credit rating. Cash-secured loans work differently, since banks essentially lend you your own funds. The bank isn't exposed to risk, because it can cash in your account if you don't repay the loan. Less risk means lower interest rates and cash-secured loans are often priced below the prime rate.
Benefits of Cash-Secured Loans
If you're trying to rebuild your credit, you might have trouble getting an unsecured credit card or a conventional loan. Banks don't usually check your credit before issuing cash-secured loans since no risk is involved. However, banks do report cash-secured loan payments to the credit bureaus. This means these loans are a good tool for boosting your credit score. And with a cash-secured loan, you can get the money you need without having to wipe out your bank account.
Due to the low interest rates, banks don't make a lot of money on cash-secured loans. For this reason, loan terms are often limited to five or 10 years. Shorter loan terms mean higher payments and some banks don't let you pay off the loan with the cash you used to secure it. If your bank does allow you to do this, you may have to pay an early withdrawal penalty for cashing in your CD before the term ends.