What are collateral loans?

A low credit score can sometimes keep you from getting a loan you need. You may be able to qualify for certain types of loans if you can pledge an item or asset of value. These types of loans are called collateral loans.

Collateral loans include:

• Mortgages
• Auto loans
• Home equity loans and home equity lines of credit (HELOCs)
• Secured credit cards
• Secured personal loans

Let’s explore how collateral loans work, look at their advantages and disadvantages, and check out some other financing alternatives that might be perfect for you.

What is collateral?

Lenders collect collateral to cover the borrowed amount if the borrower defaults. It’s common for riskier loans, such as when the borrower has a low credit score or the loan is for a large amount. It’s also common when you’re using the loan to buy an asset of value. The asset you’re buying becomes the collateral for the loan the buyer is using to purchase it.

What collateral is used for loans?

Traditional banks, credit unions, and private lenders typically accept a variety of items and assets as collateral. Common types of collateral include:

• Real estate property. If you default on a loan secured by your property’s equity, the lender can repossess it. Mortgages, home equity loans, and home equity lines of credit (HELOCs) are secured by the equity in the borrower’s home.
• Cars or other vehicles. Your car acts as security for automobile loans (or other types, as well). Just like with a home loan, though, you could lose your vehicle if you fall behind on monthly payments.
• Personal property. Some lenders often accept a valuable item, such as jewelry, art, or other collectibles, as collateral to secure a loan. However, this type of item must often be appraised before the loan can be approved.
• Cash accounts. Savings, money market accounts, and certificates of deposit can be used as collateral for a loan. However, a lender is unlikely to approve a loan amount higher than the account’s balance.
• Investment products. Stocks, bonds, and mutual funds are commonly accepted as collateral. However, if the market fluctuates and their value drops below your remaining loan balance, you may need to add extra funds to cover the difference.

How does collateral work for a loan?

Collateral gives lenders confidence when they approve your loan for a simple reason: They know there’s a safeguard if payments stop. For borrowers, it can motivate them to pay the loan, because no one wants to lose their home or car.

In some cases, a lender may offer a borrower a lower interest rate on their loan due to the security that collateral provides.

How to get a collateral loan

Here are the steps you should follow when you apply for a collateral loan:

1. Check your credit report. This is the first step to take when considering a loan. Your credit score can determine your interest rate, so it can help to make sure your score is as good as possible before applying. If you find errors in your credit report, you could have them fixed and help create a higher credit score in the process.
2. Get prequalified and shop lenders. Getting prequalified for a loan gives you a good idea of the loan amount and rate you can receive from specific lenders. Compare these quotes to find the lender with the best deal.
3. Choose your collateral. Unlike home or auto loans (which are backed by your property and car, respectively), some lenders let you determine the collateral for your loan. So go through your available assets — taking the lender’s requirements into account — and decide what you’re comfortable putting forward as collateral.
4. Organize your documents. Make sure you have all the required documents to initiate the loan process, such as bank statements, pay stubs, and tax forms. Lenders may also require proof that you own the collateral in question.
5. Submit an application. Once you’ve chosen a lender and completed the above steps, submit a full application for your desired loan. Be aware that you’ll face a hard inquiry on your credit that can temporarily bring your credit score down.
6. Secure the funds and start repayment. After a certain time, you’ll hear whether you’ve been approved for the loan. If approved, your lender will begin charging your monthly payments shortly after you receive your funds.

Pros and cons of collateral loans

Collateral loans have their benefits, but they also have some drawbacks.

Pros

• Borrowers with a low credit score can more easily get approved for a loan. That’s because lenders tend to focus more on the value of your collateral rather than your credit history, giving you a chance to secure financing despite a less-than-optimal credit score.
• Collateral can qualify a borrower for a larger loan amount, because your valuable assets can unlock access to more substantial funding than you might have expected.
• Lenders may offer a lower interest rate for a collateralized loan, as the presence of the collateral itself reduces the lender’s risk.

Cons

• Borrowers who default can lose their collateral assets. In other words, if you don’t pay the loan back on time, you can lose whatever you put up to back the loan.
• The application and approval processes can take longer with a collateral loan, especially if an appraisal of your collateral is required. The extra time needed for asset evaluation means you’ll need to get the process started earlier if you have a specific timeline.
• Collateral loans, as mentioned, require that you pledge an item or asset of value to secure the loan. This allows you to put your existing assets to work for you, so consider it a way to unlock the hidden financial potential in things you already own.

Alternatives to collateral loans

If a collateral loan doesn’t sound right to you, consider these other financing options.

Unsecured personal loans

Most personal loans are unsecured, which typically means the terms are based on your creditworthiness and debt-to-income ratio. In most cases, these loans are more restrictive in allowing you to use your loan funds.

The benefits of an unsecured loan include that you don’t risk losing any assets if you default. However, missing or stopping payments will seriously hurt your credit and ability to qualify for future financing.

Co-signed loans

Taking out a loan with a co-signer means that person becomes responsible for paying back the loan if you stop making payments. This can work in theory, but it could also strain the relationship if you miss payments because they hurt both parties’ credit scores.

No interest credit cards

Some card companies offer a promotional period with a 0% annual percentage rate when you sign up. This period typically lasts 6 – 21 months, allowing you to pay down your balance interest-free. If you go beyond that time frame, you may be subject to an interest rate well above 20%.

Payday loans

Payday loans provide immediate funds that are due for repayment by the date of your next paycheck. Often, there’s no credit check with this type of loan, and you get your money immediately. However, the APR on a payday loan can reach the staggering rate of 400% or more.

Loans from friends or family

If you want to avoid these hassles, consider turning to friends or family for a loan. This process is more straightforward than most, and friends and family typically don’t charge interest on the loan. It may help both parties, though, to draw up some sort of contract for the loan — as Robert Frost says, “Good fences make good neighbors.”

But while these types of loans are less complicated, remember that the lender usually expects to be repaid in full. If you’re unable to do so, it could strain your relationship.

Is a collateralized loan right for you?

Collateral loans aren’t for everyone, but they might work for you if you don’t have a sky-high credit score, you own valuable assets, and you need access to a large amount of money.

These loans offer compelling advantages, but it’s important that you take a clear-eyed approach to your repayment ability since defaulting means losing your asset. Also, keep in mind that if you use appreciating assets like real estate or investments as collateral, you’ll want to consult a tax professional about potential capital gains implications if you need to sell the asset later.

If a collateral loan doesn’t feel like the right fit, remember that you have other options to explore, including unsecured personal loans, co-signed loans, and more.

FAQ

Here are some questions that typically arise when people consider collateral loans.

Do I need collateral for a personal loan?

It depends on the type of loan. Some personal loans typically don’t require collateral to apply, but other types of personal loans do.

Can I use my car as collateral for a loan?

Yes, vehicles can be used as collateral. If you take out an auto loan, for instance, the financed vehicle will be the collateral to secure the loan.

Do banks give collateral loans?

Many traditional banks, credit unions, and private lenders offer collateral loans. These loans are often secured personal loans backed by a savings account, CD, or vehicle that the borrower owns.

Is it easier to get a loan with collateral?

Yes, collateral loans are often easier to obtain. Your collateral backs the loan and guarantees the lender will be repaid regardless of whether the borrower stops making payments. This can make a lender more likely to approve a borrower with a lower credit score.

The bottom line: Collateral loans offer financial solutions

Your path to financial success doesn’t have to end with a less-than-perfect credit score — in fact, it can be just getting started. Collateral loans represent a strong opportunity to turn the assets you already own into the financing solution you need, often with better rates and terms than you might have thought possible.

If you’re ready to explore how your existing assets can unlock new possibilities, a collateral loan might be precisely the tool to help you achieve your goals and take that next important step forward.

To estimate your interest rate on a personal loan, start an application today with Rocket Loans^SM.