Passbook loans: Paying to borrow your own money

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If you need funds but don’t have strong credit, a passbook loan might help you address both needs. Passbook loans — sometimes called pledge savings loans — are a type of secured loan that uses your savings account balance as collateral.

These loans are offered by financial institutions, like banks and credit unions, and can be a convenient way to borrow money while rebuilding your credit. But there are considerable risks to this loan option, too.

Learn how passbook loans work and the pros and cons of borrowing against your own money.

How does a passbook loan work?

To be eligible for a passbook loan, you need a funded savings account or certificate of deposit account. This account is usually with the institution you intend on borrowing from.

The passbook loan amount is based on the balance in your savings account. Banks then use your savings account balance as a guarantee for the loan. If you fail to repay the loan, it applies your savings funds toward the loan balance you owe.

Your lender will place a savings account hold on the amount you borrowed for the passbook loan. During this time, you won’t have access to this sum in any way. However, the locked savings funds continue accruing interest at the standard annual percentage yield.

As you make installment payments toward the loan, the bank releases the same amount from your withheld savings funds. By the time you’ve repaid your loan in whole, you’ll regain access to 100 percent of your savings collateral.

Should you get a passbook loan?

Why would anyone pay to borrow their own money? Why not just use the money in the savings account?

One reason is to establish credit. If the goal is to improve your credit profile, it’s a good idea to check with your bank about whether it reports passbook loans to Experian, Equifax or TransUnion before proceeding.

It can be a psychological reason for some borrowers as well. Some people hate to see their savings account balance drop; others are worried that they’ll never again have the discipline to replenish the account. Instead of depleting their savings account, some people prefer to take a passbook loan.

If you have strong credit, borrowing against your own money places the financial risk needlessly on you instead of the financial institution. A low-interest unsecured loan or 0% APR credit card might be an alternative. However, if borrowing money is the best way forward for your credit, a passbook loan can be an option to consider.

What are the pros and cons of borrowing from your savings?

There are a handful of benefits that passbook loans can offer, but there are also still several downsides to keep in mind.

Pros

  • Lower interest rates. The interest rates on passbook loans are typically as low as 2 percent APR, compared to the average unsecured personal loan rate of 10.49%.
  • Minimal requirements. Because taking out a loan with a savings account acts as collateral, credit requirements and approval are less stringent.
  • Helps rebuild credit. If you make consistent, on-time payments during the life of the loan, your credit score might get a boost. If this is your main reason for taking out a passbook loan, ask whether the lender reports payment activities to the credit bureaus.
  • Earns savings interest. The portion of your savings that’s held by the bank still grows interest. This can slightly reduce the overall cost of borrowing a passbook loan.

Cons

  • Might not improve your credit. It’s not always a good idea to rely on passbook loans for credit building, as not all lenders report these payments to credit bureaus. Plus, if you make late payments on your passbook loan, your credit will take a hit.
  • No safety net in an emergency.  If an unexpected expense comes up and you need to pay it, you risk defaulting on the passbook loan. Even if you aren’t in danger of defaulting on the loan, you have no access to the entirety of your savings fund. If this your only emergency fund and a crisis arises, you have no money.
  • You’re paying to borrow your own money. Ultimately, whatever loan amount you’re approved for means you have those funds already socked away in your savings account. You’re paying the bank for permission to use your own funds.

The bottom line

Passbook loans may seem like an attractive option on the surface, but proceed with caution. Because the loan is secured by some or all of your savings balance, you will have limited access to your savings until the money you borrowed has been repaid. In addition, you’ll be responsible for paying interest on your own money, and making late payments can hurt your credit score.

If you’re looking for the best way to borrow money, be sure to do plenty of research when choosing which loan is right for you.

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