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A passbook loan is a type of loan that uses your savings account balance as collateral. Terms and conditions vary widely, but generally you’ll continue earning interest on the portion of your savings that’s serving as collateral for the passbook loan. However, until you repay the loan, you will not have access to those funds in your account. If loan payments are not made, the bank keeps the money from your savings account.
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 just 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 borrowing money is the best way forward for a borrower, a passbook loan may be one of the best options. “The advantages of passbook loans include typically much lower interest rates compared to unsecured loans or credit cards and easy credit approval,” says Katie Bossler of GreenPath Financial Wellness, a nonprofit financial coaching organization. The interest rates on passbook loans may be as low as 2 percentage points above the APY of the savings account, meaning that if your savings account earns 1 percent, you may only have to pay 3 percent in interest on your loan.
Downsides of borrowing from your savings
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Still, there are several downsides to keep in mind with regard to passbook loans. For instance, it’s not always a good idea to rely on passbook loans for credit building, as not all lenders report passbook loans to credit bureaus. And if you make late payments on your passbook loan, your credit will take a hit.
Perhaps most critically, if an unexpected expense comes along that must be paid, you might find it necessary to default on the passbook loan. Even if you aren’t in danger of defaulting on the loan, your savings account, up to the balance of the loan, is collateral, and you have no access to those funds. So if it’s your emergency fund and a crisis arises, you have no money.
“The bank will put a hold on your account up to the loan amount,” says Steve Sexton, CEO of Sexton Advisory Group. “If your passbook loan balance is equal to your savings account balance that means you have no access to those funds in the event of an emergency. It’s always important to make sure you have at least three months of expenses saved in your emergency fund – in addition to the collateral you’re using for your passbook loan.”
Additionally, you have to take into consideration the fact that you’ll be paying interest in order to borrow your own money. “The consumer ties up savings and also pays two or three times more than what is being earned in interest, as interest on the loan,” says Michael Sullivan, personal financial consultant for nonprofit financial education organization Take Charge America.
The bottom line
Passbook loans may seem like an attractive option on the surface, but proceed with caution. Since 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.