What Are Collateral Loans And How Do They Work?

7 Min Read
Updated Dec. 19, 2023
Written By
Ashley Kilroy
Women unpacking boxes in new home.

With great power comes great responsibility – and the same can be said for loans backed by collateral. Securing a loan with an asset provides access to substantial funds while offering lenders a level of security unparalleled by unsecured alternatives. Whether you’re considering a mortgage loan, auto loan or other secured option, collateral loans empower you to take the next step with your financial plans. But you need to be responsible with paying it back, since your property is at risk.

What Is A Collateral Loan?

A collateral loan is a debt the borrower takes on by providing an asset to guarantee repayment. Also called a secured loan, a collateral loan requires the borrower to offer an asset to assure the lender of the borrower’s intent to pay the loan in full. If the borrower fails to repay the loan, the lender has the right to take the asset as payment for the remaining balance due.

Borrowers use various assets to secure loans. For example, you can provide a retirement account, vehicle or real estate as collateral. Doing so reduces the risk for the lender because they can seize the asset if you default on the loan.

Collateral loans come in many forms. For example, mortgages are collateral loans, and the real estate is collateral on the loan. The lender holds a lien on the mortgaged property, a mechanism that gives another entity conditional rights to your collateral if you default on the terms of the agreement. If you can’t pay your mortgage, your lender can take the house back and sell it to pay off the loan. On the other hand, if you consistently make payments and eventually fully pay off the loan, the lender takes the lien off your property.

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What Types Of Loan Are Guaranteed By Collateral?

Lenders typically assess the value of the collateral to ensure it covers a specific portion of the loan amount. 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.

With a mortgage, you can undergo foreclosure if you default. If you lender has made good faith attempts to contact you regarding your delinquency they can move forward with starting the process to foreclose on the property.

Home Equity Loans

As the name implies, home equity loans also use your house as collateral. These loans leverage 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 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. For this reason, lenders usually set a loan-to-value (LTV) ratio requirement to home equity loans to ensure your home’s value will cover an unpaid loan balance.  

Auto Loans And Other Vehicle Loans

Auto loans 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 and other vehicle loans.

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

Lenders providing business loans often ask owners or stakeholders to put up business-owned assets as collateral. Specifically, collateral for this loan includes real estate, inventory, equipment, and receivable invoices. In addition, these loans exclude the business owner’s personal assets to shield them from financial peril.

How Do Collateral Loans Work?

Applying for a collateral loan involves several steps to protect both the borrower and the lender. Here’s how collateral loans work:

  1. Evaluate your financial situation: Assess your financial standing to ensure you can afford the loan. 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. In addition, you can use a loan repayment calculator to check what size of loan your budget can afford.
  1. 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 itself 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.
  2. 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.  
  3. Gather documentation and apply: Prepare the required documents, which may include:
    • 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)

Then, complete the loan application provided by the lender. You’ll provide personal information, details about the collateral, loan amount, and loan purpose. The lender will conduct a hard credit check to assess your creditworthiness and verify the information in the application.

What Are The Pros And Cons Of Collateral Loans?

Collateral loans have advantages and disadvantages for borrowers to be mindful of.

Pros Of Collateral Loans

Here are the benefits borrowers will receive with a collateral loan:

  • Offer lower interest rates: A collateral loan may reduce the financial risk for the lender. As a result, lenders might provide better interest rates for this loan than for an unsecured loan, reducing the loan cost.
  • May let you borrow more: Your collateral’s value can also help you obtain a larger loan than solely relying on your credit.
  • Can help you build credit: Collateral loans may add diversity to your credit mix. Plus, paying a collateral loan on time and in full can help you establish a better credit score.

Cons Of Collateral Loans

Collateral loans also involve the following drawbacks:

  • Risk of losing asset: Collateral is a safety net for lenders when borrowers fail to repay the loan. In these cases, the borrower loses the asset securing the loan.
  • Longer approval period: Collateralized loans involve a more intensive approval process because the lender evaluates the asset securing the loan. As a result, borrowers in a pinch might find a secured loan to move too slowly for their needs.

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What Types Of Lenders Offer 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:

  1. Banks and credit unions: Traditional financial institutions like banks and credit unions offer a broad range of collateral loans, including mortgages, home equity loans, and vehicle loans.
  2. 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.
  3. Specialized lenders: Some lenders specialize in specific types of collateral, such as auto lenders that focus exclusively on vehicle loans.

Are All Collateral Loans A Good Idea?

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.

However, some collateral loan types are exorbitant and involve high risk. For example, same day loans have unfavorable terms, often giving borrowers several weeks to pay back the owed amount. In addition, same day lenders usually charge hefty fees and high interest rates. These factors make the loans unpayable for most borrowers, virtually guaranteeing the loss of the collateral. Similarly, pawn shop loans impose week- or month-long terms and can result in the loss of items of sentimental value, such as family heirlooms or prized possessions.

In addition, hard money loans use collateral and impose more aggressive terms than conventional loans. As a result, a solid financial plan is necessary when taking out a collateral loan. Doing so involves understanding how to repay the loan and the risk of losing the collateral.

The Bottom Line

Collateral loans allow borrowers to acquire a loan 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. It’s recommended for borrowers to thoroughly evaluate their financial position before committing to a collateral loan. If you’re looking for a larger collateral loan like a mortgage,  to determine which loan option is right for you.

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