I received an interesting offer in the mail from my credit union. It’s for a savings secured loan. The credit union offers to give me a loan if I pledge an equal amount in my savings account as collateral for the loan. If I pledge $10,000, they will lend me $10,000. If I pledge $50,000, they will lend me $50,000.
The loan is a fixed rate loan. For a term up to 5 years, the interest rate would be 2% above the current rate paid on the savings account. The savings account pays 0.8% at this time. So the rate on the loan would be 2.8%.
I will continue to receive interest on my savings, at the same rate the credit union pays to other members. The interest rate on the savings account is of course subject to change by the credit union depending on the market conditions and the competitive environment. They are not going to single me out and give me a low rate only because I have a loan.
I will not be able to withdraw the part of my savings pledged as collateral. As I make payments on the loan and the outstanding loan balance goes down, a corresponding amount of my savings will also be freed up for withdrawals.
That’s the deal. Is it a good one or not? If you need money for something, would you take it?
Borrowing and Keeping Cash At the Same Time
At a first glance it would seem strange to simultaneously borrow money at a higher interest rate and keep cash earning a lower rate. If you think about it for a minute, you know it happens all the time. Anybody having a mortgage at 3% surely has some money in a savings account earning less than 1%.
That’s for liquidity. If you have an emergency, you can spend your reserve. However, with a savings secured loan, your pledged collateral is frozen. If you have an emergency, you can’t use your savings anyway.
So, instead of getting a savings secured loan, why not just spend the money in your savings account on whatever it is you need the loan for — pay off higher rate debt, home improvement, education, etc.?
Raise Credit Score
The letter from the credit union mentions building credit as a benefit for the savings secured loan. It’s true. The loan and your timely repayments will show up on your credit report. It can help raise your credit score.
With a savings secured loan, the bank sets a repayment schedule and automatically deducts the monthly payments from your bank account. After the loan is paid off, you still have your savings.
If you don’t get the loan but spend down your own savings, there’s no guarantee you will build the savings back up. Although you can also set up automatic transfers to rebuild your savings, it’s just easier for people to find excuses to break those transfers than to default on a loan.
Poor Man’s Interest Rate Swap
From the recent media coverage about the LIBOR scandal, you probably heard many cities and other government agencies bought interest rate swaps from investment banks. They would pay a fixed interest rate to the banks and receive variable interest rates based on LIBOR from the banks. Because the LIBOR was allegedly set lower than what it should’ve been, the cities are suing the banks for what they should’ve been paid.
It’s a diversion. The interest rate swaps turned out to be a bad deal for the cities because LIBOR has come down big time since the cities bought the interest rate swaps. Even if LIBOR wasn’t set artificially lower, it would still come down a lot after the Fed set the Fed Funds rate to zero. Now the cities are still paying the fixed rate and getting practically nothing from the banks. Cities want to weasel out of the deal but then they face a large early termination fee. So they sue and create the impression that their ill fate is caused by the banks fudging the LIBOR.
Interest rate swaps are for the big boys. The savings secured loan from the credit union is a poor man’s interest rate swap. You pay a fixed rate on the loan and you receive a variable rate on the savings account. It’s a bad deal when the variable rate goes down or stays low but it could be a good deal if the variable rate shoots up.
It doesn’t seem likely we are getting back to 5% yield on money market funds any time soon. Back then I made a calculator just to figure out which money market fund is the best. Nowadays any money market fund is just as bad as the other.
Although I’m not going to take a savings secured loan, I see it can be helpful to some people for raising their credit scores and enforcing a savings discipline, plus a shot at rising interest rate.