A bad credit score can cost you hundreds, if not thousands, of dollars a year, according to a study by the Consumer Federation of America (CFA). The CFA found, for example, that a poor credit score would increase your interest charges on a typical auto loan by more than $5,000.
For the average consumer without enough cash to pay for a car, home or other large purchase without the help of credit, establishing an excellent credit history is paramount.
But getting credit without a good credit score can be tough. The good news is if you have money set aside in a savings account, you can use it to get a savings-secured loan and start rebuilding your credit.
What is a savings-secured loan?
There are many types of secured loans, including most auto and mortgage loans. But with a savings-secured loan, you use a savings or money market account or a certificate of deposit (CD) as collateral for your loan instead of a physical asset.
Depending on the financial institution, the amount of the loan can be equal to the amount of savings you’re using as collateral, but it also might limit your loan to, say, 90 percent of what you have saved. Each lender has a different minimum loan amount, but some offer loans starting at just a couple of hundred dollars.
If you get approved, the bank or credit union typically will make the amount unavailable for withdrawals. Then, as you pay back the loan, you’ll not only start improving your credit through on-time payments, but you’ll also get your savings back when you pay off the loan.
In the event that you default, however, the bank or credit union can use the collateral to pay off the loan.
Credit unions are generally more likely to offer savings-secured loans, but some big banks, such as Wells Fargo, also offer them.
The pros of a savings-secured loan
If you’re wondering how best to rebuild your credit, consider these advantages to using a savings-secured loan.
1. They can be easy to get
Since the full amount of the loan is secured by collateral that’s easy to liquidate, secured-savings loans pose an extremely low risk for financial institutions. You may need to provide income information to prove that you can repay the loan, but don’t expect much hassle in general.
2. They offer competitive interest rates
Again, because the risk is so low, banks and credit unions can afford to charge relatively low interest rates on savings-secured loans. Also, rates are typically fixed, so you don’t have to worry about your rate changing over time. For example, as of March 14, 2018, Digital Federal Credit Union offers an annual percentage rate as low as 3.50% on its savings-secured loan.
Of course, you may end up with a higher rate, but it likely will be lower than what you’d pay on an unsecured loan or a credit card.
3. You can use the loan money for anything
Since you’re looking to rebuild your credit, the best course of action is to keep the cash from your loan in a checking or savings account and use it to repay the loan.
But if you need the cash for something else or want to use it as an emergency fund until you pay off the loan, you have the flexibility to do that.
The cons of savings-secured loans
Like any credit product, a savings-secured loan isn’t right for everyone. Here are a few drawbacks to consider before applying for one.
1. You take all the risk
Since your loan is secured by your savings, the financial institution doesn’t take on much risk by lending you money. But if you’re halfway through repaying your loan and need your savings to cover an unexpected expense, you’re out of luck. You’re also at risk of losing your collateral if you can’t repay the loan, even if you’re almost finished paying it off.
2. You’ll pay interest
While savings-secured loans offer relatively low-interest rates, that’s not quite as good as paying no interest at all. For example, if you apply for a secured credit card instead and pay your balance on time and in full each month, you’ll never pay a dime in interest. Of course, secured credit cards typically charge high-interest rates, so if you’d be tempted to overspend, you’d be better off with a savings-secured loan.
3. You might incur fees
Depending on the bank or credit union, you may have to pay a fee to process the loan. For example, Wells Fargo charges a $75 origination fee on its savings-secured loan. Credit unions are more likely to forego extra fees on their loans.
Is a savings-secured loan worth it?
If you’re interested in improving your credit, a savings-secured loan is a great way to do it. But it’s not the only way. If you can get a secured credit card and use it responsibly, you’ll get the benefit of building credit without paying any interest.
But if credit cards helped get you into this mess, you might be willing to pay a little interest on a savings-secured loan to improve your credit.
Before you make a decision, compare loan minimums and rates with multiple banks and credit unions in your area. The more research you do, the easier it’ll be to secure the best deal.
If you’re concerned about your credit, you can check your three credit reports for free once a year. To track your credit more regularly, Credit.com’s free Credit Report Card is an easy-to-understand breakdown of your credit report information that uses letter grades—plus you get two free credit scores updated each month.
Image credit iStock