An equity-backed loan, designed for short-term borrowing needs, uses your own money in a savings account as collateral. In addition to providing a convenient way to borrow, secured equity loans can help build and replenish credit when paid off on time.
Here’s how to decide if a secured equity loan is good for improving your credit.
How Shared Secured Loans Work
Equity-backed loans use your interest-bearing account – savings, money market, or certificate of deposit – as collateral. They are called equity-backed loans because of their association with credit unions. âCredit union clients technically own part of the institution, so they have a share of the property, and their accounts are called sharing accounts,â says Justin Pritchard, certified financial planner with Approach Financial Planning in Montrose, Colorado.
Banks also offer these loans, but may call them loans secured by savings.
Besides the source of collateral, secured equity loans are not that different from other types of secured personal loans, says Pritchard.
âThese are usually one-time loans where you get a lump sum and then spend the money where you need it,â he says. “The credit union can put money into your account, then you can transfer the money or write a check to pay for your needs.”
During this time, the bank or credit union keeps your savings as collateral.
“The lender ‘locks’ the deposit account to prevent a withdrawal and simultaneously lends you the account balance,” said James Garvey, CEO and co-founder of the credit company Self Lender. Once you have paid off the loan, your funds are released.
If you don’t pay off the loan, the lender can keep your savings to pay off the debt.
Banks and credit unions can set different loan limits. For example, the minimum loan can range from $ 200 to $ 500, while the maximum can be up to 100% of your savings or CD account balance.
How to qualify for a secured equity loan
One of the advantages of secured equity loans is that they can be easier to obtain compared to other types of personal loans.
Having your savings as collateral usually means banks are taking very little risk, says Pritchard. Therefore, “they’re more willing to approve your loan if you have less than perfect credit or less income than they might prefer,” he says.
Depending on the requirements of the bank or credit union, approval of a loan secured by shares can be quick. You apply for a loan, then the lender checks your savings and approves your loan application.
Unlike other types of loans, a secured equity loan does not require a careful review of your credit rating for approval. Since you’re technically borrowing from yourself rather than the bank or credit union, eligibility may be more dependent on how much you have in your savings account.
This doesn’t mean that your credit score doesn’t matter for a loan secured by stocks. Your credit history can still affect the interest rate you pay to borrow.
Share the conditions of the secured loan
Lenders charge interest on equity-backed loans, and rates can be comparable to unsecured personal loans for borrowers with excellent credit, explains Pritchard.
Typically, credit unions or banks set the loan rate based on the interest rate on your savings account, adding 1% to 3%. If you get 1% interest on a CD, for example, you might only be paying 2-4% on a loan secured by stocks.
And unlike a credit card, which has a variable interest rate, a secured equity loan usually has a fixed rate. This means that your rate will not increase over time, giving you predictability in payments and protection if interest rates rise after you take out the loan.
Also, the time you have to repay a loan secured by equity may vary depending on the lender. But lenders typically allow five to 15 years to repay a loan secured by equity or savings.
Extending the loan term can make it easier to repay a larger equity loan because it can lower your monthly payment. Remember, the longer the term of the loan, the more interest you will pay over the term of the loan.
The advantage is that your savings continue to earn interest while you pay off the loan. Any dividends you earn can help offset interest costs. Of course, since the interest rate on your loan is typically 1% to 3% higher than the earning rate on your deposit account, you will always pay more interest than you earn.
Why use a shared secured loan?
Garvey says that one of the main advantages of using an equity loan is the ability to create credit.
A secured equity loan is a type of installment loan. Making installment loan payments can help boost your credit score because payment history carries the most weight in credit score calculations.
An installment loan can also improve your score in a different way if it improves your credit mix. While payment history is 35% of your FICO credit score, the credit mix – that is, the types of credit you use – is 10%. Credit scoring models favor people who use both installment loans and revolving credit accounts, such as credit cards, responsibly. If you already have a credit card, adding a secured equity loan to your credit history and paying it off on time could add points to your score.
You might think of an equity loan as a stepping stone to other types of credit. For example, if you want to buy a home, establishing your score with a secured equity loan could make it easier to qualify for a mortgage.
Besides the potential effect on credit rating, the convenience factor contributes to the attractiveness of secured equity loans. You can use them for almost anything, including debt consolidation, says Pritchard.
And he says they could be an alternative to home equity loans. âThey can also make sense for smaller home improvement projects, because you may be able to avoid set-up costs and pay off debt in five to seven years,â Pritchard said.
Similar to a secured equity loan, a home equity loan uses the value of your home to secure the loan. But home equity loans typically have a more complex approval and closing process and terms of five to 15 years, which can make a small project payout longer than it’s worth.
However, a significant downside to equity-backed loans, Garvey says, is that you have to use your savings as collateral. As a borrower, you bear most of the risk; the lender keeps your savings while you pay off the loan. If an unforeseen but necessary expense arises, it could wipe out your savings and prevent you from paying off your loan. And defaulting on a loan could wreak havoc on your credit.
Credit loan alternatives
Secured equity and savings loans aren’t your only options for building credit and meeting your short-term financial needs.
Another choice is a credit loan, offered by banks, credit unions and online lenders. When you are approved for a credit building loan, the lender keeps the amount you borrowed in a bank account while you make payments to build up credit. You receive the money after the loan is fully paid off.
It’s a bit like a loan secured by stocks, except you don’t have to tie up your savings as collateral. And instead of accessing the funds at the start of the loan, you get them at the end. Think of it as a structured savings plan that can help you improve your credit history.
âThe advantages of credit loans are the ability to create credit and save money at the same time without having to provide an initial deposit,â Garvey explains. But credit loans may not allow you to borrow as much as a loan secured by stocks, he says. Most credit loans are limited to $ 500 to $ 1,500, although some loans can be as high as $ 5,000. With a secured equity loan, you could borrow more than that if you have the funds in your deposit account.
Other borrowing options that build credit include secured and unsecured personal loans, as well as secured and unsecured credit cards.
With a secured personal loan, you will always have to offer the lender some type of collateral, although it does not have to be cash savings. For example, you might be able to get a loan with a car title, property you own, or an investment. Secured loans may offer lower interest rates than unsecured loans because you reduce the risk to the lender, but like a secured equity loan, you risk losing your collateral if you default on your payment. An unsecured loan eliminates this risk, but expect a higher interest rate to offset the higher risk to the lender.
Opening a secured credit card usually requires a cash deposit, but this type of card can also help create or replenish credit. Aside from deposit, these cards work the same as unsecured cards, with some even allowing you to earn rewards on your purchases.
When comparing loan and credit card options, pay attention to fees, APRs, and repayment terms. And don’t forget to practice these habits to improve your credit score:
- Always pay your bills on time.
- Keep credit card balances at 30% of your credit limit or less, or pay off in full each month.
- Keep old credit accounts open unless there is a compelling reason to close them.
- Use a mix of different types of credit.
- Apply for new credit only when necessary.