What Are Collateral Loans?

A collateral loan is a loan secured by an asset like a home, car, or piece of jewelry. As a borrower, you agree that the lender can seize your asset if you default on the loan. This reduces the lender’s risk, which can end up being advantageous for you.

Here’s a closer look at the ins and outs of collateral loans, including how they work and the pros and cons.

How do collateral loans work?

Collateral loans require you to pledge property, such as a car or a home, to get the loan. The lender then places a lien on your property while you’re making payments. If you fail to repay the loan according to the contract, the lender can seize and sell your property to recover its losses.

Collateral loans are often structured as term loans with installment payments. The lender provides you with a lump sum amount upfront and you repay it, plus interest and fees (if applicable), over a set term.  

Pros and cons of collateral loans

Collateral loans come with various perks but also a few disadvantages. Here’s what you should know: 

Pros

• Easier to qualify: Collateral loans come with more lenient eligibility requirements than their unsecured counterparts, so they can be easier to get if you have poor or no credit. 
• Lower interest rates than unsecured loans: Lenders often offer lower interest rates and fees on collateral loans than unsecured loans due to the lower level of risk they’re assuming. 
• Higher loan limits: Collateral may enable lenders to offer higher loan amounts due to the ability to recoup their funds regardless of a default. 
• Longer repayment periods: Collateral can enable a lender to trust you with longer repayment periods, such as 30 years on a mortgage. 

Cons

• Collateral at risk: If you default on a loan payment, the lender can seize your property without needing to sue you. 
• Longer application process: Lenders often need to inspect and/or appraise collateral, which can cause a longer loan application and approval process. 

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How to apply for a collateral loan

Here are the general steps you can take to apply for a collateral loan:

• Compare lenders: You’ll need to find reputable lenders that offer the loan type you need. For example, if you’re looking for a mortgage, shop around for home loan lenders. If you want a secured personal loan, look for personal loan lenders. In addition to the loan type, look for companies with suitable eligibility requirements for your financial situation, competitive rates, and good reviews from past borrowers. Once you find a few potential lenders, contact them to request quotes. 
• Submit an application: You’ll often need to provide information about your living situation, debt, income, employment, assets, and collateral. Lenders also typically require documents like pay stubs or tax returns to back up your claims.
• Review and sign the loan agreement: Once you qualify, you’ll be sent a loan agreement to review and sign. Carefully look over your loan’s terms before signing.
• Begin repaying your loan: Repay your loan on time to avoid late fees, losing your collateral, and damaging your credit. Set up autopay to avoid missing any payments.

The aim is to find out the loan amount, annual percentage rate (APR), term, fees, monthly payment, and total cost lenders are willing to offer you. Then, you can compare multiple offers side by side to see which is the best fit. 

Types of collateral loans

Collateral loans are very common in the U.S. and come in various forms. Here are some of the popular types you can find on the market: 

• Secured personal loans: A secured personal loan is a term loan that requires some type of collateral and allows you to use the funds however you choose.
• Secured credit cards: A secured credit card requires you to make a deposit to gain access to a credit line. The deposit then acts as collateral for the credit line, and you can use the funds however you’d like.
• Mortgages: A mortgageis a secured term loan that you can use to buy a home. The home then acts as collateral for the loan. 
• Home equity loans: A home equity loan, also known as a second mortgage, is a term loan secured by the equity you have in your home. You can use the loan’s funds however you’d like. 
• Auto loans: Auto loans, or car loans, are secured term loans you use to purchase vehicles. The vehicle then acts as collateral for the loan. 
• Car title loans: A car title loan is a term loan secured by a vehicle that’s owned outright. You can use the loan funds however you choose.
• Life insurance loans: Permanent life insurance policies often acquire cash value over time. Many insurance providers then allow you to take out loans secured by your cash value account.
• 401(k) loans: 401(k) retirement account providers often allow you to take out loans secured by your account balance, which you can then use however you choose.
• Secured business loans: Business loan lenders may require various types of collateral for secured business loans, including invoices, future sales, equipment, inventory, or machinery.

In many cases, you can get pre-approved for a loan before your collateral is inspected and appraised. If you’re looking to get a mortgage, for example, you can get pre-approved for a loan amount before you find the property you want to buy. However, the application and approval process can vary by lender and loan type, so it's best to check with potential lenders to find out how they work.

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Keep Reading: How to Apply for a Personal Loan

Alternatives to collateral loans

Not too keen on collateral loans? You can also look into going the collateral-free route. 

Lenders offer unsecured loans in many forms, including personal loans, credit cards, and business loans. Without any collateral to consider, approval is primarily based on your credit scores, credit history, and income. The main upsides are fast approvals and great offers if you have good-to-excellent credit. The potential downsides are stricter eligibility requirements, and potentially lower loan amounts, higher rates, and shorter terms.

Another important factor to consider about unsecured loans is that the lender won’t have the right to seize your property if you default. Instead, they typically sell bad debts to collection agencies that pursue you for the balance. However, lenders can also sue you. If they win, the court may allow them to then seize your assets to recoup their losses. 

FAQ 

What are the requirements to qualify for a collateral loan?

The requirements to qualify for a collateral loan vary by lender and loan type. However, you’ll typically need to meet the lender’s income, debt-to-income ratio (DTI), and credit score minimums, and provide proof of income, identity, and residence. Additionally, you’ll often need to provide documentation for your collateral and may need proof of insurance. 

Can I use any type of asset as collateral?

The type of asset you can use as collateral for a loan varies by lender and loan type. Certain loan types, like mortgages and auto loans, for example, are secured by the asset that you purchase with the loan. However, lenders that offer other loan types — like secured personal loans, pawn shop loans, and business loans — may accept various asset types. 

How does the value of my collateral affect the loan amount?

Lenders assess the value of your collateral to determine the loan amount you can get. In most cases, they’ll only offer you a percentage of the total value to ensure their interests are protected. For example, you can only borrow up to 80% of a home’s value with a conventional mortgage without needing mortgage insurance, according to Freddie Mac. The percentage that you can borrow will vary by lender and loan type. 

What happens if I default on a collateral loan?

If you default on a collateral loan, the lender can seize and sell the asset that’s securing the loan to recover their losses. For example, if you put down a deposit on a secured credit card, the credit card issuer could apply the deposit to your outstanding balance. In the case of a car loan, the lender can repossess your vehicle and sell it. In the case of a mortgage, your home can go into foreclosure. 

Can I get a collateral loan with bad credit?

You may be able to get a collateral loan with bad credit, as the collateral helps to reduce the risk a lender faces in issuing loans. If you default, the lender can seize the asset, sell it, and recoup its costs. However, borrower requirements vary between lenders and loan types. Your best bet is to research the eligibility requirements of lenders offering the loan type you want to find those that work with bad credit borrowers. 

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