What is collateral? Understanding secured loans

One way to make borrowing more affordable is to put down collateral. What’s collateral? It’s an asset you agree to forfeit to the lender as compensation if you default on the loan. A loan with collateral is called a secured loan, and usually comes with better terms and a lower interest rate than unsecured loans. Mortgages and auto loans are the most common examples of secured loans, but there are other types.

Key takeaways:

• Collateral is an asset used as a guarantee of payment to a lender or financial institution, typically a valuable item such as real estate, a vehicle, or an investment.
• Collateralized loans, or secured loans, can help increase your approval odds, especially if you're having a hard time qualifying for an unsecured loan.
• If you miss payments and default on your loan, you could lose that asset, so make sure the loan fits your budget.

How lenders define collateral

Collateral is an asset used to secure a loan with a financial institution like a bank or credit union. If you fail to make payments and default on the loan, the lender can take ownership of the asset and sell it to recover its money. It’s a way for lenders to reduce the risk of a loan.

Lenders may accept all types of collateral – from property and vehicles to investments or savings – if it holds enough value to cover the loan amount.

How does collateral work?

The type of collateral a lender accepts usually depends on the kind of loan you’re applying for. In many cases, the item you’re financing, such as property or a car, serves as the collateral. However, other valuable assets, such as a savings account, jewelry, stocks, or a certificate of deposit, also can be used.

When you apply for a secured loan, lenders review your finances. They’ll check your credit score, payment history, and debt-to-income ratio to determine their risk in lending you money. They’ll also assess the value of the item you’re offering as collateral to help determine how much you can borrow.

Once the loan is paid off or refinanced, the original lender releases its claim to the collateral. But if the borrower can’t repay the loan and defaults, the lender has the right to take and sell the asset to recover some of the money they lost.

How does collateral work for a personal loan?

Personal loans come in two types: secured and unsecured. The main difference is that a secured loan requires collateral, and an unsecured loan does not.

Most personal loans are unsecured. That means the lender trusts you to repay the loan plus interest within the agreed time, based on your credit and financial history. To qualify for an unsecured personal loan, you’ll typically need a credit score of at least 580. But keep in mind that higher scores may help you qualify for lower interest rates and better terms.

If your credit isn’t strong, getting approved for an unsecured loan might be tough. In that case, a secured loan may be a good alternative. Offering collateral reduces the lender’s risk, making it more willing to extend financing.

Types of collateral loans

Here are some of the most common types of loans and financial products that use collateral.

• Mortgages: Also referred to as a home loan, a mortgage helps you buy real estate, whether you’re financing your primary residence or an investment property. The property you’re buying serves as the collateral.
• Car loans: Whether you’re buying a truck, convertible, or sedan, the car you finance acts as the collateral for the loan.
• Secured credit cards: This type of credit card requires a cash deposit as collateral. Therefore, if you miss payments, the lender can use that deposit to cover your balance.
• Secured personal loans: In some cases, lenders will let you use an asset like a car, boat, savings account, or even your home to secure a personal loan.
• Home equity loans: This type of loan lets you borrow against the equity in your home, which is the value of the property minus how much you still owe on your mortgage. But just like a mortgage, you’re putting your home on the line if you can’t repay it.
• Home equity line of credit: A HELOC also lets you borrow against the equity in your home, using the house as collateral. But instead of giving you a lump sum amount, it works like a credit card. You can borrow, repay, and borrow again during the draw period, and as you pay back what you owe, your available credit is refilled.
• Small-business loans: Some lenders require collateral for business loans. This could include your building, equipment, or other business assets.

Examples of collateral for a secured loan

As mentioned earlier, lenders and financial institutions may accept a wide range of collateral. Some common examples include:

• Vehicles like ATVs, boats, cars, motorcycles, or RVs
• Savings accounts and investments like stocks, bonds, or mutual funds
• Insurance policies
• Valuables such as fine art, antiques, collectibles, or jewelry

In general, you can’t use money from a retirement account, like a 401(k) or IRA, as collateral for a loan. The IRS doesn’t allow it. That said, some 401(k) plans let you borrow money directly from your account. But doing so can be risky and complicated. For example, if you leave your job or can’t repay the loan on time, you may face taxes and penalties.

Should you use collateral for a loan?

You may not have a choice when it comes to using your home or car as collateral for a mortgage or auto loan. But when it comes to personal loans, you might. If you have the option, choosing a secured personal loan has some benefits.

Because the lender has something to fall back on if you don’t repay, you may qualify for a lower interest rate, a longer repayment term, or even a larger loan amount. If your credit score could use some work, offering collateral can also help improve your chances of getting approved.

One of the biggest risks with a secured loan is losing whatever asset you put up as collateral if you default on the loan. That’s why it’s important to make sure the monthly payments fit within your budget comfortably before you agree to the loan.

If you do end up running into some financial difficulty, reach out to your lender as soon as possible to let them know. Lenders usually are willing to work with borrowers by offering deferment options or updated payment plans. At the end of the day, most lenders would rather help you stay on track than repossess your property.

FAQ

Here are answers to some common questions about collateral.

Can I use my IRA as collateral for a loan?

No, the IRS prohibits the use of retirement accounts, including IRAs and 401(k)s, as collateral for a loan. If you try to use one as collateral, it could count as a withdrawal and come with taxes and early withdrawal penalties.

What can be used as collateral for a personal loan?

You can use a wide range of assets, such as your car, a savings account, investments, or even valuables like jewelry or art as collateral. Essentially, you can use anything your lender considers valuable and is willing to accept to secure your loan.

Can I get approved for a loan without collateral?

Yes, but it depends on the loan. Many personal loans are unsecured and don’t require you to put up anything valuable to qualify. But if you're going for a secured loan, you’ll need to offer something the lender can take if you don’t make payments.

How do I get a loan with collateral?

To get a collateral loan, here are some steps to follow:

• Choose a lender
• Select an accepted form of collateral like a savings account
• Gather your documents and personal details, such as your ID and proof of income
• Apply with the lender

If you meet the lender's requirements, they’ll use your collateral to secure the loan and offer terms based on your financial situation.

The bottom line: Using collateral for a personal loan offers benefits and risks

Using collateral can come with some risk, but it may also help you qualify for better terms, like a lower interest rate or a longer repayment period. Lenders benefit, too, since they have the option to recover some of their losses if you default on the loan.

However, if you don’t have an asset with enough value to secure the loan amount you need, an unsecured loan might be a better fit. You can learn more about how unsecured loans work and weigh the pros and cons to see which option makes the most sense for your financial goals.

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