What it means
The name comes from the old paper passbook that recorded savings deposits. Today the loan is secured by a savings account or deposit held at the same bank.
The lender places a hold on the amount, so the borrower cannot withdraw it until the loan is repaid. Since the lender can take the money if the borrower fails to pay, the risk is very low.
That is why the interest rate is usually only a small margin above the rate the savings earn. A borrower with weak credit can often qualify when other loans would be refused.
The main use is to build a credit record. The borrower takes a small loan, makes regular payments, and the lender reports the payments to credit agencies.
Over time, this can improve the borrower's credit score and allow access to normal credit. The cost to the borrower is the difference between the loan interest and the interest earned on the savings.
If the savings earn 2% and the loan costs 4%, the net cost is 2% of the amount. The borrower also gives up access to the cash during the loan.
The nuance is that the loan is not free money. If payments are missed, the lender can use the savings to repay the debt, and the borrower may end up with a damaged record as well as lost savings.
Compared with other ways to build credit, the passbook loan is simple and fairly cheap. A secured credit card is another option, while a loan has the advantage of fixed payments that encourage regular saving.
Borrowers should compare fees, check how the lender reports and make sure the term suits their budget before signing.
In practice
Real-world examples.
Example
A young professional with no credit history deposits $2,000 and takes a passbook loan for the same amount. She repays it over twelve months. The record of on-time payments helps her qualify for a credit card later. She checks first that the lender reports to the main credit agencies, because that is the point of the loan.
Example
A small business owner needs cash for two months but does not want to sell investments. He borrows against his savings account at a rate slightly above what the deposit earns. He repays the loan when a customer pays a large invoice. Because the loan is secured on his own deposit, he pays only a small net cost for the short period.
Example
A parent helps a student by opening a savings account and taking a loan secured on it. The student makes the payments and builds a record. The parent keeps the funds until the loan is repaid. The student gets a better credit record, and the parent's money is safe as long as payments are made.
Formula
Calculation
Net annual cost = loan amount x (loan rate - savings rate)
A borrower holds $10,000 in a savings account earning 2% a year. The bank lends her $10,000 at 4%, with the savings held as security. Interest on the loan for a year is 10,000 x 0.04 = $400. Interest earned on the savings is 10,000 x 0.02 = $200. Net cost = 400 - 200 = $200, which is 10,000 x (0.04 - 0.02) = $200 a year, or 2% of the loan.Case study
Seen in the real world.
Fairhaven Credit Union is an illustrative, fictional lender that offered passbook loans to members with limited credit history. One member, Ms Dlamini, deposited $3,000 and borrowed the same amount at a rate 2 percentage points above the savings rate.
She made twelve on-time payments, and the credit union reported each of them. At the end of the year her net cost was about $60 in interest, and her credit score had risen enough to qualify for an unsecured loan.
In the illustrative result, the member regarded the small cost as a worthwhile price for a better credit record. The lesson was that the loan is a tool for building credit, not a way of getting extra money. Fairhaven later published a short guide showing members how the loan works and what it costs.
Watch out
Common mistakes.
- Thinking the borrower can still withdraw the savings, when the lender normally freezes the amount until the loan is repaid.
- Missing payments because the loan is secured, when the lender can take the savings and the missed payments can harm the credit record.
- Choosing a lender that does not report to credit agencies, which removes the main benefit of the loan.
Questions
People also ask.
Why is the interest rate low?
Because the lender holds cash as security, there is almost no risk of loss, so it charges only a small margin. If the borrower defaults, the lender simply applies the savings to the debt.
Can I use a passbook loan to build credit?
Yes, if the lender reports payments to credit agencies, regular on-time payments can improve your record over time. The best use is for a modest amount that you can comfortably repay, so you do not risk losing your savings.
What happens if I do not repay?
The lender can use the money in the savings account to settle the debt, and you lose the savings.
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