Debtadviser: Use passbook or CD loans to boost credit score

Want to improve or establish your credit? Try a passbook loan or a CD loan.

From 40 million to 50 million Americans are considered "underbanked" -- they have no credit or a "thin" credit file. Add to that the millions of families with bad credit from unemployment, mortgage meltdowns or other loan defaults, and you have a lot of people wondering what they can do to improve their credit plight.

One of the major factors needed to establish or improve your credit score is to successfully repay a loan. But getting a loan to show a potential creditor the ability to repay it can be daunting. Your answer may be a passbook loan. It's a useful credit-building tool, like a secured credit card, that is fairly simple to obtain.

A passbook savings loan, sometimes called a passport loan or a CD loan, is simple to obtain because it is 100 percent secured by the borrower's own money, which is deposited with the bank that's offering the loan. Here's how it works.

A deposit in the amount of money requested to borrow is placed on deposit with the bank. Access to the money on deposit is not allowed until the CD loan or passbook loan is repaid.

Repayment terms for passbook loans or CD loans are typically flexible and come with a relatively low interest rate. A loan of $500 should be sufficient, since it's for the purpose of improving your credit report, although for credit-score rebuilding, the larger the CD loan or passbook loan, the better.

Although the credit-score firms, FICO and VantageScore, don't divulge the inner workings of their credit scores for fear of manipulation, it stands to reason that a larger CD loan or passbook loan counts for more than a smaller one. Certainly in mortgage-default situations, one of the reasons given for the large credit-score drop is the loan size. So, the opposite should also be the case.

Lenders may have a CD secured loan for larger loans for persons with more cash than credit. Some banks will make a CD loan up to $50,000 secured by a five-year CD. Using non-CD savings deposits, some are willing to stretch repayment to up to 10 years. The money on deposit to secure a passbook loan continues to earn interest while the loan is repaid, thereby reducing the effective interest rate.

A passbook loan is classed as a secured installment loan. These loans require regular payments in the same amount made weekly, monthly or whatever the terms are for the passbook loan for a specified period of time. An installment loan on a credit report illustrates to potential lenders the ability to fulfill the terms of a loan by making regular set payments for an extended period of time.

To fully benefit from a passbook loan, payments must be made on time, every time, to improve both your credit score and credit report. In addition, the bank must report the passbook loan to the three major credit bureaus. Not all banks report these loans, so for purposes of improving credit, it is important to choose a bank that does report passbook loans to the bureaus. There is one more plus to a passbook loan. When the loan is paid off and credit is improved, money in savings remains to be used.

(Steve Bucci is author of "Credit Repair Kit for Dummies," coauthor of "Managing Your Money All-In-One for Dummies" and a personal-finance coach. If you have a question for Steve, e-mail debtadviser(at)bankrate.com. For more Debt Adviser columns, go to bankrate.com.)