To obtain a collateral loan, you must offer a valuable asset, such as your home or car, to act as security for the funds. Why? To protect the debt. These types of loans can help borrowers take out large sums of money, often at lower interest rates, but they come with inherent risks. If you default on the loan, you could lose your home, car, or another asset.
Understanding how a collateral loan works and its risks and rewards can help you decide if this is the right financial fit for you and your family.
Key Takeaways:
- Collateral loans are a type of security loan requiring an asset (item of value) to secure the debt on the loan.
- Examples of collateral loans include mortgages, auto loans, and car title loans.
- Collateral can include a home, bonds, a vehicle, or even jewelry. Different lenders (and loan products) require and accept different forms of collateral.
- If a borrower defaults on a secured or collateral loan, the lender can repossess the asset that secures the loan. Car repossessions and mortgage foreclosures are examples of forfeited collateral during a loan default.
What Is A Collateral Loan?
A collateral loan is a secured loan. It is typically (but not always) a lump-sum loan backed by a valuable asset such as a home, vehicle, or money account. The debt is “secured” by the collateral, which guarantees that the lender will be repaid according to the loan terms. If the borrower fails to repay the loan, the lender can take the asset as payment for the remaining balance due.
Like most personal loans, loans that don’t require any collateral are known as “unsecured” loans. A borrower’s eligibility for an unsecured loan is determined primarily based on a lender’s evaluation of the borrower’s credit score and debt-to-income ratio (DTI).
Examples Of Collateral
Any form of collateral should carry a value equal to or greater than the requested loan amount. Lenders also prefer assets they can easily collect and sell in the event of a default. Assets typically used as collateral include the following:
- Real estate (home equity)
- Vehicles
- Machinery or equipment
- Liquid assets such as stocks, investments, or savings accounts
- Insurance policies such as life insurance
- Other collectibles or valuables
There are also many kinds of collateral (secured) loans. The most common is a mortgage loan where the lender holds a lien on the mortgaged property. If you can’t pay your mortgage, your lender can take the house (your collateral) back and sell it to pay off the loan. An automobile loan is another common collateral loan – if you can’t make your car payments, the lender will repossess the car.
On the other hand, if you consistently make payments and eventually fully pay off a collateral loan, the lender will remove the lien from your property, vehicle, money account, or other asset.
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Securing Loans Using Collateral
When you apply for a collateral loan, the lender must approve the asset you use to secure the loan. In the case of a home-related mortgage, usually an appraiser will work on behalf of the lender to verify the worth of the property. A car dealer will appraise the market value of your vehicle, and so on, depending on the type of collateral and loan.
Here are the loan types you can secure with collateral:
Mortgage Loans
A mortgage is slightly different from a standard collateral loan. In this case, real estate is used as collateral for the loan, even though the borrower doesn’t own it yet. When a borrower goes into default on a mortgage loan, you may end up in foreclosure, but it takes time. Most lenders won’t start foreclosure proceedings until you miss four consecutive mortgage payments (120 days or four months).
By this time, your lender will have likely made good faith attempts to contact you regarding your delinquency (after 30 days) and they can move forward with starting the process to foreclose on the property. You can often negotiate before your home goes up for auction (the final state in foreclosure). Most lenders would prefer to avoid foreclosing on borrowers’ homes, so determining your options is always a good idea if you cannot make payments.
Home Equity Loans
As the name implies, home equity loans also use your house as collateral. Your loan-to-value ratio (LTV) will depend on the equity you’ve built over time. For instance, say you have $200,000 of your mortgage remaining on your home valued at $300,000. You can usually borrow about 80% ($80,000) against your equity and secure the debt with your house.
As with a mortgage, the lender can foreclose on the property if you default. In addition, if there is a downturn in the housing market and your home loses its value, you could owe more in mortgage loans than your home is worth.
For this reason, lenders usually set a LTV ratio requirement for home equity loans to ensure your home’s value will cover an unpaid loan balance.
Auto And Other Vehicle Loans
Auto and other vehicle financing loans use the vehicle you purchase as collateral. Similar to a mortgage, failure to meet your loan obligations may result in having the automobile repossessed.
The same principle applies to boat loans. Like all collateral loans, boat loans come with risks in addition to the loss of your asset.
When a car or other vehicle, such as a boat, is repossessed due to a default on payments, it will hurt your credit, making it difficult to qualify for a new car or other vehicle loan.
Secured Personal Loans
You can secure a personal loan with assets like stocks, bonds, art, jewelry, and other assets that have a tangible value. Remember, most personal loans are unsecured, meaning you don’t need collateral to obtain one. As a result, personal loans requiring collateral are typically for borrowers with credit issues or sizable loan needs.
Business Loans And Farm Loans
Lenders providing business or farm loans often ask owners or stakeholders to use business-owned assets as collateral. Specifically, collateral for these types of loans includes real estate, inventory, livestock, crops, equipment, and receivable invoices.
If you take out a business loan, your personal assets, such as your home or retirement account, are excluded as collateral, but if you take out a farm loan, they may not be, depending on the terms and conditions of the loan.
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How Do Collateral Loans Work?
Applying for a collateral loan involves several steps to protect both the borrower and the lender. Here are the steps to take for collateral loans:
- Evaluate your financial situation: First, assess your financial standing using a loan repayment calculator to check what loan size your budget and financial profile can afford. Lenders will consider your income, existing debts, credit history, and credit score. Remember, a solid financial position can prevent the need for collateral and help you receive an unsecured loan instead.
- Determine the type of collateral: Your asset collection will dictate what you can provide as collateral. Remember, for a mortgage or vehicle loan, the purchase will provide the necessary collateral. Your lender will likely require a home appraisal for a mortgage or home equity loan. In addition, you could secure a loan to expand your business with the building or equipment the business uses.
- Research lenders: Next, compare offers from different lenders, including banks, credit unions, and online lenders. Consider their interest rates, terms, fees, and reputation. In addition, you can consider the lender’s requirements for collateral, including the type, condition, and value. Gathering multiple offers allows you to choose a lender with favorable terms for your needs.
- Gather documentation and apply: Prepare the required documents:
- Personal identification (driver’s license, passport)
- Proof of ownership for the collateral
- Documentation showing the value of the collateral (property appraisal, vehicle valuation)
- Income verification (pay stubs, tax returns)
Complete the loan application provided by the lender by providing all the personal information mentioned above, plus details about the collateral, loan amount, and loan purpose. The lender will then conduct a hard credit check to assess your creditworthiness and verify the information in the application.
Where Do You Find Lenders For Collateral Loans?
Collateral loans are available through most lenders. Remember, the loan type can influence where you can receive a specific secured loan. For instance, some lenders don’t offer mortgages and home equity loans. In addition, you can shop for auto loans with conventional lenders and car dealerships. Here’s a rundown of the lenders you can get a collateral loan from:
- Banks and credit unions: Traditional financial institutions such as banks and credit unions offer a broad range of collateral loans, including mortgages, home equity loans, and vehicle loans.
- Online lenders: Online lending platforms and financial technology companies have become increasingly popular for collateral loans. They often offer competitive rates and convenient application processes.
- Specialized lenders: Some lenders specialize in specific types of collateral, such as auto lenders that focus exclusively on vehicle loans.
- Hard money lenders: Hard money loans are typically taken out by house flippers, real estate investors, and borrowers who don’t qualify for a typical mortgage. These lenders often quickly process funds, with the real estate purchased acting as the collateral on the debt. Hard money loans usually have higher interest rates, shorter repayment terms, and less oversight, making them potentially risky.
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What Are The Pros And Cons Of Collateral Loans?
Collateral loans can be a viable option for specific situations. For instance, these loans often have lower interest rates than unsecured ones. They can also help you rebuild your credit if you make timely payments. Secured loans also serve a wide range of purposes, from home renovations to debt consolidation.
Like any loans, collateral loans can come with risks. If you default on a collateral loan, you risk losing a valuable asset, such as your home or vehicle, while damaging your credit.
Certain kinds of collateral loans can take longer to close. This is because the lender has to appraise your asset before they can even start the loan proceedings. In some cases, collateral loans, such as a hard-money loan, typically used for flipping real estate, may impose more aggressive terms than conventional loans. Same-day loans may require collateral, but not always.
Whatever kind of collateral loan you decide to use, you should have a solid financial plan. This involves understanding how to repay the loan and the risk of losing the collateral.
Pros And Cons Of Collateral Loans
| Pros | Cons |
|---|---|
| It may help you rebuild and improve your credit score. | Defaulting on the loan will harm your credit score. |
| Borrowers without strong credit may qualify for this loan. | If you put up your home or car as collateral, you risk losing it if you cannot repay the loan. |
| Secure loans may have lower interest rates, reducing the total cost of the loan. | Collateral loans have a longer approval period. |
| You may qualify for a larger loan based on your collateral, such as equity in your home or a valuable piece of art. | Payday or hard-money collateral loans usually have aggressive terms and higher interest rates than a home equity loan or other types of collateral loans. |
The Bottom Line About Collateral Loans
In most cases, collateral loans allow borrowers to acquire the funds needed to purchase a home, car, or other large purchase while assuring lenders of repayment through pledged assets.
While collateral loans offer advantages such as lower interest rates and higher borrowing limits, they also entail risks, particularly the potential loss of the pledged asset in case of default. Borrowers should thoroughly evaluate their financial position before committing to a collateral loan.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
