How Does a CD Loan Work?
Purchasing a certificate of deposit involves depositing an amount of money for a specified length of time. You contractually agree to leave this deposit with the bank for the time period you choose. You can borrow up to 100 percent of your CD amount at low interest rates, since your CD is the collateral. You typically pay an interest rate only 2 to 3 percent above the interest rate the bank promises to pay you for your CD.
Banks will renew your CD loan in most instances, but not forever. Before your bank tells you that your loan balance must be zero, design a reasonable plan to pay off your CD loan at a specified future date. This will make your bank more comfortable with you, encouraging it to renew your CD loan one or more times with the knowledge that you're planning repayment by a promised date.
If you have no credit or a credit report with some negative items, a CD loan may be a good way to establish or improve your credit. Because you offer cash collateral equal to the amount of your loan, some banks don't even check your credit. Should the bank check your credit and find it less than perfect, it usually will still make the loan since it has little risk of loss.
Withdrawing Versus Borrowing
When you need funds and have a CD, you have two options: make an early withdrawal, canceling the CD, or borrow an amount up to the balance of the CD. Most CD agreements include penalties for early withdrawal. Penalties involve forfeiting some interest you have already earned. Depending on your CD agreement and your bank, you may face a three- to six-month interest forfeiture penalty. Evaluate this potential cost against the total projected cost of a CD loan. You may learn that your loan cost and interest penalties could be roughly equal.
One of the advantages of CD loans is cost. Since you're really borrowing your own money, banks charge low interest on these loans. Typically, you'll pay only 2 to 3 percent more than the interest rate your CD is earning. For example, if your CD is earning 1 1/2 percent, you should get a quote at around 3 1/2 to 4 1/2 percent interest. CD and passbook loans are the least expensive form of borrowing from banks.
Another feature of CD loans is the fast approval time, particularly if you need funds quickly for emergencies or investments. Since your money is on deposit for a specified time period, the bank is totally secure, risking its interest earnings only if you default. Approvals don't require waiting for or evaluating credit reports or income verifications, as you're offering dollar-for-dollar cash collateral. Loan officers need only verify that you have the CD you're pledging to approve your loan request. Typically, your approval will come in a matter of minutes from application submission.