When you open a certificate of deposit, you agree to keep a sum of money in the account for a period of time and your bank agrees to pay you interest on the CD. You assume the role of the creditor, and your bank assumes of the role of the debtor and uses your money to fund other people's loans. However, you can borrow money against a CD, in which case you end up you end up being both a creditor and a debtor of the bank.
When you take out a CD loan, you pledge your CD as collateral for the debt. If you do not repay the loan then your bank can liquidate the CD and use the money to payoff the loan. When you take out a secured loan, the amount of the loan cannot exceed the value of the collateral. Some banks allow you to have a loan-to-value ratio of 100 percent on CD secured loans. Other banks cap the LTV at 80 or 90 percent to ensure that the bank can recoup both the principal and some of the interest if you default on the debt.
You cannot cash in your CD until your have paid off your debt, so your loan term must exceed your CD term. You have to pay interest on a CD loan but you also earn interest on your CD during the loan term. However, the rate your pay always exceeds the rate you earn and the margin between the two interest rates allows your bank to covers its administrative costs and to make a profit. Generally, CD loans cost less than other types of loans, since banks have total control of the collateral and face less risk than with other types of collateral secured loans, such as mortgages.
Almost anyone can qualify for a CD loan since banks do not normally check your credit score because these loans pose no risk to the bank. People with little or no credit history often use CD secured loans to improve their credit scores. However, due to loan underwriting rules, you must have some kind of income source if you want to take out a CD loan. People who are trying to build their net-worth also use CD secured loans because they can list the CD as a cash asset even when they have secured a loan against it.
Although loans secured by CD investments enable people with poor credit to gain access to inexpensive money, most CD loans have short-term times. The shorter the term time, the larger the monthly payment which means that people with minimal income may struggle to repay large dollar loans. Some people take out CD loans because they want to avoid the premature withdrawal penalties that you incur if you cash in a CD early. However, the interest that you pay on the loan may more than offset those penalties.
- Keith Brofsky/Photodisc/Getty Images