Savings-based collateral (SBCol) — also known as "deposit" or "cash" collateral — is legal tender locked in deposit accounts and simultaneously pledged to partially or wholly secure select loans and credit cards. Examples include secured credit card deposits and savings-secured loans, as well as credit-builder loans & cards.
Savings-based collateral is not the same as cash equivalent collateral, which includes marketable securities, documents of title, bonds, and other highly-liquid but non-cash assets.
It is also not the same as the "capacity factor" in creditworthiness, which is the assumption that borrowers with savings have the capacity to settle debt obligations even if the funds are not part of the debt agreement. Capacity is closely related to recourse, which is a lender right to recover funds by obtaining un-pledged borrower assets in a court of law.
Savings-based collateral enables lenders to accept subprime borrowers or high-risk projects that would otherwise pose an unacceptable amount of risk.
Summary
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Savings-based collateral is cash held on deposit.
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Secured credit card deposits are a popular example.
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It is most common in the credit building process.
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It is not the same as recourse, which refers to unpledged assets lenders acquire in court after default.
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It is not creditworthiness "capacity," which refers to income and assets as evidence of trustworthiness.
Definition
Savings-based collateral is cash deposited in locked accounts and pledged as security for a loan or revolving line of credit. Deposit account types includes savings accounts, interest-bearing savings accounts, and certificates of deposit.
For example, Patelco Credit Union offers loans against savings up to 5 years and against certificates of deposit for the life of the account.
Examples
Common examples of products with savings-based collateral are
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Secured credit card deposits. Secured credit cards require the borrower deposit the credit limit of the card in order to use it. The cardholder essentially "borrows" from him/herself.
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Savings-secured loans. SSLs operate like secured cards but under an installment structure. The borrower pledges savings in an account in exchange for the same amount in principal.
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Payment-secured credit builder loans. PSCBLs are the most common credit builder loan type. They require the borrower make payments into a secured account until the pay off the total value of the loan, at which point it is distributed.
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Fully-secured credit builder loans. FSCBLs are an category of credit builder loans that include savings-secured loans. They require the loan value be deposited upfront into an account from which the lender draws loan payments.
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Rolling prepaid accounts on credit builder cards. Among other features, credit builder cards use rolling prepaid & checking accounts to determine the cardholders credit limit biweekly or monthly.
The Concept of Collateral
Collateral refers to an agreement in which borrowers promise to transfer ownership of assets in the case they are unable to reimburse money provided by a lender.
Imagine, for example, an acquaintance requests to borrow $1,000 to purchase a new TV. She promises to reimburse the money over 3 months plus interest, and promises to hand over the TV if she cannot make the payments.
You can now make money on interest, or in the worst case scenario take the TV for personal use or resell it. The TV is collateral.
Asset Type
It's important to note that savings-based collateral fundamentally differs from all other collateral because its asset type is cold, hard cash.
Physical collateral, such as houses and vehicles, is intuitive because it makes sense for borrowers to avoid selling them for cash and instead simply pledge them for debt. The work to sell them may even cost more than loan interest.
For example, imagine a borrower with $500 in savings who wants to purchase a stroller of the same value. He could take out a loan and pay interest, but using his savings directly would cost less. However, the same borrower with a $500 lawn mower and no cash would need to sell the machine before acquiring the stroller. The effort is higher in this case.
These dynamics beg the question: why would a savings-based collateral loan borrower pledge her own cash in order to obtain the bank's cash? The answer is that the purpose of savings based collateral is not funding.
Purpose
At its core, the purpose of savings-based collateral is to mitigate lender risk so it can justify extending money to high-risk borrowers (aka those with below-average credit) and non-capital intensive projects.
Given that savings-based collateral is cash, the extended credit has no financing value. Why? Because the borrower can simply use her money in savings to fund a purchase rather than pay interest on a loan.
Instead, extended credit is used for non-financing activities such as credit building and establishing financial accounts for regulatory purposes. The most intuitive use is credit builder loans.
Use Case: Credit Building
The most common use case for savings-based collateral is credit building. SBCol is a key component of payment-secured and fully-secured credit builder loans. It allows lenders to provide critical installment debt to borrowers with limited, zero, or damaged credit history.
For example, Credit Union West $250 - $5,000 credit builder loans in which the principal sits in account until the borrower pays it off and receives the funds. In this way, the principal functions like savings.
It's a win-win scenario because borrowers improve their credit for nominal interest charge, and lenders don't mind "small" income because savings-based collateral essentially eliminates their risk. They do not provide funds up front, and any non-payments impose zero cost.
Accounts that Can Hold Cash Collateral
Consumer savings-based collateral is held in three account types: savings, interest-bearing savings, and certificates of deposit.
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Savings. Savings accounts are the default account. They usually pay nominal interest but primarily serve as a safe, controlled space to hold funds.
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Interest-bearing savings. Most savings accounts generate savings, but interest-bearing savings offer annual percentage yields sufficiently large to partially counterbalance interest charges on the loan or card.
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Certificates of deposit. Certificates of deposit are similar to interest-bearing savings accounts, but they generally have more austere withdraw penalties, compensating their relatively higher interest rates.
Interest
The national average interest rates have historically been below 0.10% for savings accounts and below 0.20% for certificates of deposit. However, those values evolved rapidly to 0.5% and 1.8% after May 2022¹².
it is rare for deposit interest to surpass debt interest, otherwise the lender would not offer the loan. However, savvy borrowers can find strong offsets with research or by leaning on professionals or guided DIY plans.
Amount
Savings-based collateral values may partially cover loan proceeds, but they usually cover the full amount. For example, they are equal to principal plus interest on credit builder loans to cover the borrower's full obligation. Full coverage makes most sense because it procures lower interest rates.
Institutions
Savings accounts and certificates of deposit are available at most financial institutions, but their use as savings-based collateral is most common at credit unions that offer savings-secured loans, as well as regional banks, credit unions, and digital lenders that offer credit builder loans.
Different than Savings Recourse
A key point to remember is that savings-based collateral is not the same as recourse. Recourse is a lender's right to pursue borrower assets not outlined in the loan agreement in the case of default, whereas collateral is always formally included.
Different than Creditworthiness "Capacity"
One creditworthiness factor is capacity, which refers a borrower's income and savings as a evidence of trustworthiness. Capacity is similar to recourse in that it's not savings-based collateral but represents an asset outside the scope of the loan agreement that lenders can pursue in the case of borrower default.
Citations
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Federal Deposit Insurance Corporation. “National Deposit Rates: 12-Month CD.” FRED, Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/series/NDR12MCD.
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Federal Deposit Insurance Corporation. “National Deposit Rates: Savings.” FRED, Federal Reserve Bank of St. Louis. https://fred.stlouisfed.org/series/SNDR.
