Collateral Loans: How Getting A Loan With Collateral Works

Credit is often the key to your financing options, and having a low credit score can sometimes keep you from receiving the loan you need. You may be able to qualify for certain types of loans, though – despite your bad or mediocre credit – if you can pledge an item or asset of value. These types of loans are called collateral loans.

Let’s take a closer look at how collateral loans work, the pros and cons of collateral loans, and alternative financing options you could consider.

A collateral loan, or secured loan as it’s often called, is a loan backed by an asset of significant value, or “collateral,” that secures the loan for the borrower. Lenders may approve collateral loans for borrowers with a lower credit score because the lender can collect the borrower’s collateral to cover the loan amount if the loan goes into default.

Types of collateral loans include:

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

How Does Collateral Work For A Loan?

Collateral helps assure a lender they’ll get their money back even if the borrower stops making payments. Additionally, it can provide incentive for borrowers to keep up with their payments so they don’t risk losing their asset.

In some cases, a lender may grant a borrower a lower interest rate on their loan because of the security the collateral provides.

What Is Considered Collateral For A Loan?

Traditional banks, credit unions and private lenders can accept a variety of items and assets as collateral. Here are some common types of collateral:

• Real estate property: Mortgages, home equity loans and HELOCs are secured by the equity in the borrower’s home. Defaulting on a loan secured by this equity can result in the lender repossessing the property.
• Cars or other vehicles: Car and auto loans are secured by the vehicle being financed. Similar to a home loan, the borrower could lose their vehicle if they fall behind on their monthly payments.
• Personal property: A lender can often accept an item of value – jewelry, art or other kinds of collectibles – as collateral to secure a loan. Personal items like this will often need to be appraised before the loan can be approved.
• Cash accounts: Savings and money market accounts, as well as certificates of deposit (CDs), can be used to secure a loan. A lender likely won’t approve a loan amount higher than the account’s balance.
• Investment products: Stocks, bonds and mutual funds are often accepted as collateral. A risk here, though, is that your investments could potentially drop below the value of your remaining debt, in which case you’d need to provide an additional cash collateral to make up the difference.

Applying for a collateral loan works much like other loan application processes, with an extra step or two depending on your type of loan. Follow these steps when applying for a loan:

1. Check your credit report. Checking your credit report is almost always the first step when considering a loan. Your credit can determine your interest rate, so it can help to make sure your score is as good as it can be before applying.
2. Get prequalified and shop lenders. Getting prequalified for a loan gives you an estimate on the loan amount and rate you could get approved for with certain lenders. Compare these quotes to find the lender with the best deal.
3. Decide on your collateral. Unlike home or auto loans, some types of collateral loans leave the collateral up to your choosing. Look over your available assets based on a lender’s requirements and determine what you’re comfortable putting forward.
4. Organize your documents. Make sure you have all the required documents, such as bank statements, pay stubs and tax forms. Lenders may also require proof you own the collateral in question and have the asset appraised. 
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 amount of time, you’ll hear whether you’ve been approved for the loan. If approved, your lender will begin charging your monthly payments soon after you’ve received your funds.

Collateral loans don’t always leave everyone happy. Keep in mind the following pros and cons if you’re thinking of getting a collateral loan:

Pros

• Borrowers with a low credit score can get approved for a loan more easily.
• Collateral can qualify a borrower for a larger loan amount.
• Lenders may grant a lower interest rate for a collateral loan.

Cons

• Borrowers who default can lose their collateral assets.
• Application and approval processes can take longer with a collateral loan, especially if an appraisal is required.
• Collateral loans, as mentioned, require that you pledge an item or asset of value to apply.

If the cons of collateral loans outweigh the pros in your situation, consider these alternative financing options.

Unsecured Personal Loans

Most personal loans are unsecured, although some lenders also offer them as collateral loans. Without collateral attached, your approval and interest rate will be determined largely by your credit score and debt-to-income ratio (DTI). In most cases, you’re restricted somewhat on how you can use your loan funds.

With an unsecured loan, 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

If your credit isn’t impressive, maybe someone else’s is. Having a cosigner on your loan application could improve your chances of getting approved for a loan because, like with collateral loans, lenders can feel more certain they’ll get their money back.

A cosigner becomes responsible for paying back the loan in the event the borrower stops making payments. Naturally, this could strain any relationship between the borrower and cosigner, especially since missed payments will hurt both parties’ credit score.

0% APR Credit Cards

Only secured credit cards require collateral, and some card companies offer a promotional period with a 0% annual percentage rate (APR) when you sign up. This period typically lasts around 6 – 21 months, giving you the opportunity to pay down your balance interest-free. If you go beyond that time frame, though, you can get hit with a high credit card interest rate, which was above 23% on average as of mid-February.

Payday Loans

Payday loans are due for repayment by the date of your next paycheck. Often, there’s no credit check with this type of loan, and borrowers receive their funds immediately.

However, the APR on a payday loan can be exceedingly high – around 400% – and lending fees range from $10 to $30 for every $100 borrowed. Rolling the loan over incurs an additional lending fee.

With such a short repayment period and the costs of the fees and APR, payday loans can easily send borrowers into a cycle of debt.

Loans From Family Or Friends

Sometimes a good collateral loan alternative is to turn to the ones we love. Asking someone you know for some helpful funds can be simpler and more straightforward than most loan processes, and you probably won’t owe any interest on the loan either. It may help both parties, though, to draw up some sort of contract for the loan.

Keep in mind that this friend or family member, unless stated otherwise, expects you to pay them back the full amount. If you fail to do that, you could damage or lose that relationship. That’s arguably worse than losing any kind of collateral.

Here’s what people online are asking about collateral loans.

Do I need collateral for a personal loan?

Personal loans most often don’t require collateral to apply. Some types of personal loans are collateral loans, however, so personal loans can be secured or unsecured.

Rocket Loans℠ offers unsecured personal loans at fixed rates.

Can I use my car as collateral for a loan?

Yes, cars and other vehicles can be used as collateral. When taking out an auto loan, the vehicle being financed will act as the collateral to secure the loan. If pursuing a secured personal loan or other type of loan with collateral, you may have the opportunity to put up a vehicle you own to back the loan.

Do banks give collateral loans?

Yes, many traditional banks, along with credit unions and private lenders, offer collateral loans. These loans will often be secured personal loans backed by a savings account, CD or vehicle owned by the borrower.

Is it easier to get a loan with collateral?

As discussed earlier, collateral loans are often easier to get approved for. 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.

Collateral loans can be a boon to borrowers who have a low credit score, crave a lower interest rate or both. The biggest risk to defaulting on a collateral loan is losing your asset, be it a personal item, your car or your home. If you feel confident in your ability to always make your monthly payments on time, though, a collateral loan just might suit your situation.

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