What Are Collateral Loans And Are They Right For You?

Opting for a collateral loans could increase your chances of approval since they minimize the lender’s risk. With a collateral loan, if you’re unable to pay it back, your lender is less likely to lose too much on your loan’s remaining balance.

That being said, there are some significant risks if you want to take out loans with collateral, so it’s important to find out exactly what a collateral loan is and whether it’s the right fit for you.

What Is A Collateral Loan?

Collateral loans are also known as secured loans and are guaranteed by some kind of asset. When you obtain a secured loan, you offer a personal asset to assure the lender you will repay the funds in full. By providing collateral, you agree to give your lender control of your asset if you stop paying on or default on a collateral loan.

Unsecured loans, on the other hand, are not backed by collateral. You typically need to have a very strong credit history to qualify. Since you don’t guarantee the loan with a personal asset, unsecured loans are far riskier for lenders. If you miss your payments and default on your loan, your lender will not be able to recover your outstanding balance as easily.

Since secured loans involve less risk than unsecured loans, they also come with certain advantages. By putting up collateral, the borrower typically receives better terms, including higher loan amounts and lower interest rates. This loan option is also beneficial for borrowers who have a low credit score, as offering collateral often makes it easier to qualify for a loan.

How Do Collateral Loans Work?

A lender will ask that you provide some form of collateral for secured loans. Every type of loan has different requirements for what can be used as collateral. For example, taking out a mortgage would mean your home is being used as collateral; for an auto loan, your vehicle would be the collateral. Other lenders may accept assets such as a certificate of deposit (CD) or bonds.

Aside from putting down collateral, you may need to meet other borrower qualifications such as minimum credit score, debt-to-income ratio (DTI) and loan-to-value ratio (LTV) requirements.

If you default and are unable to repay the loan, your lender can seize whatever you used as collateral. After taking over your asset, your lender will sell it to recoup your loan’s outstanding balance.

Types Of Collateral Loans

There are a number of different types of collateral loans, each with a different purpose and its own terms.

Some of the most common types include:

• Mortgages: A mortgage requires you to offer your lender the property you’re purchasing as collateral. When your lender gives you the funds, they put a lien on your property. Once you pay off the mortgage in its entirety, the lien is considered satisfied and removed. However, if you don’t keep up with your mortgage payments, the lien enables your lender to seize your home and sell it to recoup their losses.
• Auto loans: When you take out an auto loan, you provide the car you purchase as collateral to secure the loan. Once you pay off the loan, the car is yours, free and clear. However, if you are unable to repay the loan, your lender is able to repossess your vehicle.
• Home equity loans: A home equity loan is a second mortgage on your home. Just like your first mortgage, the lender has the right to seize your home if you default on your payments. A home equity line of credit (HELOC) is also a type of second mortgage, except you can draw from a line of credit instead of receiving a lump sum.
• Secured credit cards: Secured credit cards are typically used by individuals who have bad credit or have not built up a credit history yet, as they can be guaranteed by a cash deposit. The amount you put down will act as your credit line, and credit card issuers have the right to keep the deposit if you fail to make payments.
• Secured personal loans: A personal loan is a type of financing that can be used for most purposes, such as debt consolidation, home improvements, auto repairs and medical expenses. To secure the loan, you typically offer an asset that meets or exceeds the value of your loan amount. Your lender can seize this asset if you fail to make payments.

Pros And Cons Of Collateral Loans

Collateral loans have both benefits and drawbacks worth considering.

Pros Of Collateral Loans

• Larger loan amounts: In many cases, like mortgages, you can borrow much more than if you were only to guarantee the loan with your signature.
• Potentially lower interest rates: Since collateral loans tend to pose less risk to the lender, you may receive a lower interest rate in return.
• Increase chances of loan application approval: Even if you have a lower credit score, the fact that a lender can recoup their losses easier could mean better chances of a loan application approval.

Cons Of Collateral Loans

• Could lose collateral: If you default or are not up to date on your loan payments, you could lose your asset. In doing so, you could lose out on a lot, especially if your asset is worth more than you still owe on your loan.
• Could be a lengthier application process: Collateral loans may require a lengthier process, especially if you need to prove the asset is yours, or that it will be transferred to you once you pay off the loan.
• Can’t choose what collateral to use: In most cases, the lender chooses what type of collateral or asset you can use when taking out a loan.

Where Can You Take Out A Collateral Loan?

Here are several places where you can take out a collateral loan:

• Banks: You may be able to submit an application online or in person.
• Credit unions: Most credit unions require you to be a member before you can apply for a loan.
• Car dealerships: Auto dealerships typically offer their own financing options if you want to purchase a car with them.
• Online lenders: Many of these types of lenders tend to offer a more streamlined application process, and in many cases, competitive interest rates.

How To Apply For Loans With Collateral

Though each lender’s criteria may vary, here are the general steps you’ll need to take to apply for a collateral or secured loan.

1. Evaluate Your Credit Score

Checking your credit score is crucial to see where you stand, and what your chances of approval may be. The higher it is, the better. Plus, knowing what your credit score is can help you narrow down lenders to ones with minimum requirements you can meet. You can also consider checking your credit report to see what else you can do to raise your credit score if you can wait a bit before applying for the loan.

2. Prequalify For The Loan

Prequalifying means you submit certain information to lenders, and it’ll let you know how much you’ll most likely qualify for, and at what terms. In many cases, you’ll only be subject to a soft credit inquiry, which won’t impact your credit score.

3. Compare Interest Rates And Loan Terms

Shopping around ensures you’re getting the best loan for your financial profile. Check a few lenders to see what rates and terms you may qualify for, and do a side-by-side comparison. Based on your needs and loan features, pick a loan that you feel is the best fit.

4. Assemble Necessary Documents

To help speed up the application process, make sure to check what documents the lender will need from you when you submit your loan application.

5. Submit Your Loan Application

Head to the lender’s website (or their local branch if applying in person), fill out all the necessary forms and submit any required documents. In some cases, the lender may ask you to create an online account so you can track the application status. If approved, the lender will ask you to sign closing documents and collect any details on where to send loan proceeds.

Collateral Loan FAQs

When it comes to borrowing funds, collateral can make all the difference in determining your qualification and terms. Here are some commonly asked questions about these types of loans.

What is collateral?

Collateral is a personal asset that a borrower uses as security for a loan. By putting up assets such as personal valuables, stocks, bonds, or real estate to secure a loan, the borrower reduces the risk involved for lenders. This typically gives a borrower access to lower interest rates and more favorable loan terms.

How do I take out a personal loan with collateral?

To take out a secured personal loan, you will need to figure out what type of loan you want and the kind of collateral required by the lender. Then when you submit an application, you will need to provide proof you have the collateral required. You’ll most likely need to sign a document stating the lender has the right to seize your asset if you default on the loan.

Can I use my car as collateral for a loan?

Yes, you can use your car as collateral for a loan, especially if it’s an auto loan. For other types of personal loans, you will need to work with your lender to see if this is an acceptable form of collateral.

What happens if I don’t repay my collateral loan?

Your lender will sell the asset to try to recover the cost of your loan and any fees incurred in the process. Hopefully the sale is enough to cover the debt in full. Otherwise, your lender may take legal action to try to get you to make up the difference.

Your credit score will likely take a considerable hit as a result of defaulting on the loan.

The Bottom Line

Collateral is an asset that you use to secure a loan. It provides your lender with the assurance that you’ll repay the money borrowed in full. Loans secured by collateral are considered less risky for lenders because they give lenders the authority to seize and sell your asset if you miss your monthly payments and default on your loan.

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