What is a Passbook Loan?
A "passbook loan" is a bygone banking term that describes a secured personal loan. In the past, any savings account opened at a bank had a corresponding passbook in which you could record future transactions. Very few banking institutions still use this passbook. Instead, account holders receive statements in the mail or choose online banking for transactions. However, the term "passbook" remains in use.
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Using the Passbook for a Loan
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A passbook loan, which is not as common now as it was 30 to 40 years ago, uses funds that are already in your account, so you need enough money in your savings account to cover the amount of the loan. The bank is not at risk with a passbook loan because you are both the lender and the borrower and the bank is not a participant.
Borrowing Your Own Money
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Even though you are borrowing money from yourself, the bank does impose some terms and conditions on borrowing against your own account. Upon approval, a few banks may also freeze the funds in your account--up to the loan amount--until you have repaid a designated amount of money. The amount a bank will loan you ranges from 50 percent to 100 percent of the funds in the account.
You still earn interest on the full amount in the account, including the loan amount. You will pay it back at an interest rate approximately 3 percent higher than the interest the bank pays to your account. -
Paying to Use Your Own Money
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If the loan amount is already in your account, why should you pay to use that money as collateral? When you need money, the least expensive option is to borrow it from yourself. Your savings account probably is earning interest at a rate of less than 1 percent. Add 3 percent to that and a passbook loan would cost just over 3.5 percent over the life of your loan. Unsecured (personal) loans can cost three or four times that amount in interest.
Some borrowers mistakenly think that they can improve their credit scores by doing a loan this way. But the truth is, most banks do not even report the activity on a passbook loan.
The Downside
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Your savings account retains the full amount of your savings--the funds for the loan come from the bank, which uses your account as collateral. If you default on the loan, you could lose your savings. Most banks have a generous grace period for passbook loans, but they eventually will remove the funds from your savings account to pay the balance on the loan. Some banks allow loans of 100 percent of the account amount. In this case, your savings account will close if you fail to make loan payments.
Think Twice
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Is your savings account also your emergency fund? If so, it's not a good idea to use it as collateral for a passbook loan, because the loan will put the outstanding balance of your reach until it's paid off.
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