The pros and cons of share-secured loans

A share-secured loan, also known as a savings-secured loan, is a type of personal loan backed by the funds in your bank or credit union account. If your loan application is approved, the financial institution will freeze the funds in your account as security. This form of loan may be easier to obtain than others, particularly if you are just starting to build your credit history.

While share-secured loans can be an effective tool for building credit, it's important to understand their role in the broader financial landscape. These loans are part of a category known as "secured loans," which also includes mortgages and auto loans. The key difference is that with share-secured loans, the collateral is cash, whereas with mortgages and auto loans, the collateral is the property or vehicle being financed. This cash collateral significantly reduces the lender's risk, which is why these loans are often more accessible to those with limited credit history.

How Share-Secured Loans Work

Financial companies that offer share-secured loans allow you to utilize funds from your accounts with them, such as a savings or money market account, as collateral for a personal loan. These forms of loans are most commonly found at credit unions, where savings accounts are known as "share accounts" and checking accounts as "share draft accounts."

The lending organization will freeze the amount you put up as collateral, but you may still earn interest while you repay the loan. Depending on the terms of your loan, you may only be able to access your collateral once you have paid off the entire debt, or it may be released gradually as you make payments.

It's worth noting that the interest rate on a share-secured loan is typically higher than the interest rate earned on the savings account used as collateral. This difference represents the cost of borrowing. For example, if your savings account earns 1% interest and your share-secured loan has a 5% interest rate, the effective cost of the loan is 4%. This structure allows the financial institution to profit from the arrangement while still offering a lower rate than many unsecured loans.

Because you're putting up your own money, lenders may be more inclined to grant loans or offer a lower interest rate due to the reduced risk. Depending on the lender, you may be able to borrow up to 100% of your collateral, or a lesser amount. If you fail to make payments and default on your loan, the lender has the right to keep the money.

Pros and Cons of Share-Secured Loans

Share-secured loans, like any other sort of borrowing, offer perks and disadvantages.

Advantages of Share-Secured Loans:

Opportunity to improve credit. Banks and credit unions often record payment information to credit bureaus, which might help you establish a credit history.

It is easier to qualify. Borrowers with minimal or poor credit history can qualify for a share-secured loan.

Competitive interest rates. These loans are less hazardous for lenders than unsecured loans, so you may be able to acquire a cheaper interest rate.

Loan flexibility. Borrowers can often employ share-secured loans for nearly any reason.

Disadvantages of Share-Secured Loans:

Money is frozen in the account. You will not be able to access the frozen funds until you have paid down or paid off your debt.

Possible collateral loss. If you fail to repay the loan, you risk losing the money in your account.

Possible fees. In addition to interest, your lender may impose costs for originating the loan. If you aren't diligent, you may end yourself paying late fees.

One often overlooked aspect of share-secured loans is their potential impact on your credit utilization ratio. This ratio, which accounts for about 30% of your FICO credit score, measures how much of your available credit you're using. When you take out a share-secured loan, it appears as a new account on your credit report, potentially increasing your total available credit. However, if the loan amount is significant compared to your other credit lines, it could temporarily increase your credit utilization ratio, potentially causing a short-term dip in your credit score. This effect typically resolves as you pay down the loan balance.

Is a Share-Secured Loan Suitable for You?

If you have low or limited credit and wish to improve it, a share-secured loan could be a smart option. Because it is easier to qualify for than many other types of loans, you may not have to go through a lengthy application and approval procedure, allowing you to receive the funds more quickly.

However, if you require a large loan or have good credit, you may want to examine other options.

It's crucial to consider your financial goals when deciding whether a share-secured loan is right for you. These loans can be particularly beneficial for those looking to establish a positive payment history or diversify their credit mix. However, they may not be the best choice if your primary goal is to access funds for a large purchase or emergency expense. In such cases, you might be better off simply using the savings you would have used as collateral, especially if the loan's interest rate is significantly higher than what your savings are earning.

Alternatives for Share-Secured Loans

Share-secured loans are not for everyone. Possible options include:

Credit cards are secured. Secured credit cards, like share-secured loans, demand a refundable cash deposit into a designated account, which often serves as the card's credit limit. However, the down payment may be less than that required for a share-secured loan. Secured credit cards may be a better alternative if you do not need to borrow a significant number of money or if you do not require funds right immediately. Having a secured credit card and paying your bills on time may also qualify you for a standard credit card after a specified length of time.

Credit-building loan. Credit-builder loans are also designed for people with limited credit history. Instead than requiring you to provide collateral, the amount borrowed is held for you in a savings or CD account. You repay the loan in installments, and the money is released to you when it is fully paid off.

Secured personal loan. This is a traditional lender's loan, which requires collateral. Instead of cash, you can utilize other sorts of assets, such as a vehicle, and you can frequently keep them while you repay the loan.

How Much Should You Have in Savings to Get a Share-Secured Loan?

The amount you need to hold on deposit in a share-secured loan varies depending on the lender and the amount you wish to borrow. In many circumstances, you will require at least a few hundred bucks.

What Interest Rate Should I Expect for a Share-Secured Loan?

Share-secured loans typically have lower interest rates than other types of personal loans, particularly unsecured loans.

How long does it take to build credit with a share-secured loan?

Your loan activity is normally reported to the credit bureaus every month. According to credit agency Experian, establishing a FICO credit score, the most widely used version, typically takes at least six months, however FICO competitor VantageScore can generate a score for you as soon as your lender files its initial report.

Can you use stocks as loan collateral?

Yes, you can. Some financial institutions, for example, provide securities-backed lines of credit (SBLOCs), which require you to pledge stock shares as security. Brokerage houses also provide margin loans based on your portfolio's worth, which are often used to purchase additional investments but can also be used for other purposes.

What is a Certificate-Secured Loan, and how does it differ from a Share-Secured Loan?

A certificate-secured loan is similar to a share-secured loan, but the lender accepts a certificate of deposit (CD) as collateral.

A share-secured loan might be a good strategy to improve credit. These loans are relatively easy to qualify for and have lower interest rates than many other forms of loans. You risk losing the money you put up as collateral if you are unable to repay the loan. If you determine that this form of loan is best for you, make sure to research around and compare rates and terms.