How Does a Passbook Loan Work?

Definition

A passbook loan is a loan that is collateralized with your savings account. Dissimilar to a standard credit account, a passbook account is a loan that--usually at a lower interest rate--borrows your own money as a safer risk for the bank. Usually these accounts are only offered through community credit unions and local banks. Despite the security, this is not the best way to build credit--nine times out of 10 these accounts are not reported to the three major credit bureaus. It is, however, a safe way to borrow money without the potential danger of negatively affecting your credit score.

Process

The first step in acquiring a passbook loan is to be an established banking customer at your local bank or credit union. This means having both a savings and checking account open in good order. Some banks will lend up to 100 percent of the balance in your savings account, some cap the loan amount at 50 percent. Check with your local bank for restrictions. Often these loans are easily processed with a simple application and no credit check. The usual risk associated with lending is mitigated because the collateral is your own savings account. Often the bank will charge between 2 percent and 3 percent over the amount you are earning on the account. You will still continue to earn interest on the money in your savings, but the bank will earn profit on the interest charged on the loan. Also, the funds being used as collateral are frozen--the bank wants to secure its collateral.

Uses

There can be various reasons to resort to a passbook loan. Some customers take advantage of these since they are easily acquired and often have lower interest rates than unsecured personal loans. Some customers enjoy doing business with community lenders. Also, customers with poor credit use these loans to access cash and build a lending relationship by demonstrating to a bank that they are a good risk while they work to reestablish their credit independent from the passbook loan. The loan that is most similar to a passbook loan is one taken against a 401(k) where employees borrow percentages of their retirement for home purchases and other investments.