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If you have no credit history or one so poor that no one will lend you money, banks and credit unions offer another option: a fixed-rate personal loan secured by a certificate of deposit.
The CD acts as collateral to get you a low interest loan. Lenders can offer low rates, even to borrowers with poor credit, since they take almost no risk: If you don’t repay your loan, they take your CD.
For fair-lending purposes, lenders have to look at some of the same borrowing criteria as they would for any other loan, but they aren’t as strict with underwriting when it’s a CD-backed personal loan, says Jonathan Patrick, senior vice president and chief lending officer of UT Federal Credit Union in Knoxville, Tennessee. If, for example, you have a higher debt-to-income ratio than is usually allowed, the bank will be less concerned about it since you’re applying for a secured loan, he says.
Who this loan is good for
While it’s low risk and low interest, this type of loan may be your best option only when it’s your lone option for establishing or rebuilding credit. Paying interest isn’t a requirement for improving your credit score; you can accomplish your goal by getting a credit card, charging 1 small expense each month and paying off the balance in full and on time.
If you can’t trust yourself with a credit card, though, it’s better to pay the interest on the personal loan.
Using a CD-secured personal loan to improve your credit score will work only if you make the payments on time, Patrick says. Even though the lender will get repaid from your CD if you default, it will still report your delinquency to the credit bureaus.
Establishing and rebuilding credit are the most common reasons consumers take out these loans, Patrick says, but others use them as a way to keep savings intact when they need extra cash. There’s a psychological benefit to knowing that you have some savings in the bank as a cushion.
You won’t be able to use that money as long as it’s acting as loan collateral, but it will become available to you again once you’ve paid off the loan. Instead of starting over at 0, you’ll still have your nest egg, though you will have paid loan interest to hang on to it. If you have a hard time accumulating savings, or if you can’t sleep at night with a 0 bank balance, a CD-secured personal loan can be a good option.
A CD-secured loan is also a good alternative to an unsecured personal loan because your interest rate will be a few points lower. Someone with fair credit may be able to find an unsecured rate of as little as 8.8%. A CD-secured loan rate might be 4%, Patrick says. Meanwhile, you’re earning 1% on your CD, making your effective interest rate just 3%.
The cheapest option, of course, is to lend to yourself by dipping into your savings.
RATE SEARCH: Check for the best rates through Bankrate’s personal loan offerings.
How to get a CD-secured personal loan
There are 2 ways to establish a CD-secured loan. You can take money from your checking or savings account and buy the CD that will secure your loan.
Or you can use a CD you already own as collateral.
Here are some restrictions to look out for when considering this type of loan:
There might be a minimum loan amount or a limit to how much you can borrow as a percentage of your CD balance. Boston-based Santander Bank, for instance, requires a minimum $1,000 loan, and you can borrow up to 98% of your balance. If you default on your loan and the bank incurs collection costs, it wants to be able to recoup its expenses plus what you borrowed.
“That small cushion helps the lender know that it will not lose money even if you fail to repay the loan,” says banking lawyer Matthew A. Cordell, leader of the financial institutions practice group at Ward and Smith in Raleigh, North Carolina.
Your loan term may be restricted. At Florida Community Bank in Weston, Florida, for example, the loan term can’t be longer than the CD term. But if you have a CD that matures in 1 month and want to take out a 12-month loan, your financial institution will usually let you roll that CD into a 12-month one without paying an early withdrawal penalty, Patrick says.
It’s more common to see CD-secured loans advertised by credit unions than by big banks. But just because you don’t see these loans advertised on a lender’s website doesn’t mean they aren’t available. Some institutions don’t advertise them since they aren’t significant money makers, Patrick says.
“These loans tend to be small-dollar and therefore not very profitable for banks,” Cordell says. “The fixed costs associated with making any loan make it difficult for a bank to earn money on a small loan.” But credit unions are obligated to make small-dollar consumer loans in exchange for getting tax-exempt status.
Watch out for extra fees
What if you already have a CD that you could cash out to get the money you need instead of borrowing?
“There is usually a penalty associated with withdrawing a long-term CD prior to maturity, and if you are in need of immediate cash, it might be more cost-effective to get a loan than to pay the penalty,” Cordell says.
Find out what early withdrawal penalty you’d have to pay, then see if you might come out ahead by using your CD to secure a loan instead.
If the loan will have costs other than interest — for example, Wells Fargo charges a $75 origination fee on CD-secured personal loans, whether you’re borrowing $3,000 or $30,000 — factor that into your calculation.
RATE SEARCH: If you choose to buy a CD, search for the best CD rates near you at Bankrate.com.