What Is a Collateral Loan? How it Works, Options, and Pros & Cons

ByG. Dautovic
May 31, 2022

When approving your loan, collateral is one of the most important factors that lenders look at. But what is collateral and how does a collateral loan work? 

Simply put, collateral is anything of value you can offer up as security against the money you’re borrowing. If you can’t repay your loan, the lender can take possession of your collateral to recoup any losses. 

In this article, we’ll take a closer look at what collateral is and how it works. We'll also discuss the different types of collateral and the pros and cons of using it when applying for a loan.

What Is a Collateral Loan?

Collateral is an asset or assets that a borrower offers to a lender as security for a loan. As the name suggests, a collateral loan is secured by such assets. If the borrower defaults on the loan, the lender can take possession of the collateral and sell it to recoup potential losses.

Collateral can take many forms, including cash, stocks, bonds, and real estate. In general, collateral must have some financial value and be easily convertible into cash.

Deciding whether or not to accept collateral is up to the lender. It depends on factors such as the type of loan and the creditworthiness of the borrower.

For example, a lender may be more likely to accept collateral when offering a loan to a small business than when offering a personal loan. Having collateral also gives borrowers some negotiating leverage when applying for a loan.

Types of Loans with Collateral

There are many different types of collateral loans, each with its specific benefits and drawbacks. 

The type of secured loan that’s right for you will depend on a number of factors, including the value of the collateral, the amount of money you need to borrow, and your personal financial situation.

Home Equity Loans

Home equity loans are among the most common types of loans with collateral. A home equity loan allows you to borrow against the equity in your home, which is the portion of your home that you own outright.

Home equity loans typically have low interest rates and can be used for various purposes, such as home improvements or debt consolidation. THe major drawback is that if you default on a home equity loan, you could lose your home.

Car Loans

Auto loans are another common type of collateral loans. As their name suggests, car loans are typically secured by the vehicle that is being purchased with the loan.

If you default on a car loan, the lender can repossess your car. One advantage of a car loan is that it can be easier to qualify for than other types of loans, such as personal loans. On the other hand, auto loans typically have higher interest rates than other types of loans.

Mortgages

A mortgage is a type of loan secured by real estate. Mortgages are typically used to purchase homes, but can also be used to refinance an existing home loan or borrow against your home's equity.

As is the case with other types of collateral, if you default on a mortgage, your financial institution can foreclose on your home. However, mortgages are popular because they typically have much lower interest rates than other loans.

Secured Personal Loans

A secured personal loan is a loan secured by collateral, such as a savings account, certificate of deposit, or piece of jewelry.

Secured personal loans typically have lower interest rates than unsecured personal loans. Of course, the flipside is that if you default on a secured personal loan, the lender can take possession of the collateral.

What's also important to note is that not all lenders accept every type of collateral. If you’re struggling to get a loan with the collateral you have at your disposal, you might also want to consider some collateral loan alternatives, such as unsecured loans or credit-builder loans.

For example, some lenders may only accept cash as collateral for a personal loan, or they may require collateral in the form of a savings account or certificate of deposit.

What Can Be Used as Collateral?

There are many things that can be used as collateral when taking out a loan. 

The most common form of collateral is property, such as a home or a car. However, other forms of collateral may also be acceptable, depending on the type of loan you are taking.

For example, some lenders may accept jewelry, art, or other valuables as collateral. On the other hand, some lenders have stricter rules and even require a cosigner when you wish to apply for a collateral loan.

A cosigner is someone who agrees to repay the loan if the borrower is unable to do so. This can be a useful option for borrowers with poor credit or no collateral. Ultimately, it is up to lenders to determine what they want to use as collateral.

The important thing to remember is that the collateral has to be of sufficient value to cover the loan amount. If the borrower does not repay the loan as agreed, the lender has the right to seize the collateral and sell it to recoup their losses. 

As such, it is crucial to carefully consider what you’re willing to use as collateral before taking out a loan.

Pros of Collateral

There are several advantages of collateral loans you should know about. We’ve listed some of them below.

Lower Interest Rate

One of the most significant advantages of using collateral is that it can help you get a lower interest rate on your loan. This is because lenders view collateral loans as less risky than unsecured loans.

As a result, they are often willing to offer lower interest rates for borrowers willing to use collateral.

More Negotiating Power

Having collateral can give you more negotiating power when applying for a loan. This is because you can offer to use your collateral to reduce the risk for the lender.

For example, if you're applying for a loan, you may be able to negotiate a lower interest rate by offering to use some of your assets as collateral.

Larger Loan Amounts 

Another advantage of using a collateral loan is that it can help you qualify for a larger loan amount. This is because lenders see secured loans as less of a risk and are more likely to approve larger loan amounts.

This can be beneficial if you're looking to get a mortgage or a car loan.

It Can Help You Build Credit

Using collateral can also help you build credit, as lenders often report collateral loans to credit agencies and all major credit bureaus.

As a result, if you make your monthly payments on time and in full, you can improve your credit score and your overall credit history.

Cons of Collateral

While there are some advantages to using collateral, there are also some drawbacks to securing a loan with collateral.

You Can Lose the Collateral

The most obvious disadvantage of using collateral is that you could lose your valued possession if you default on the loan. For example, if you put your home up as collateral for a loan and you default on the loan, the lender could foreclose and repossess it.

This is why it's important to only use collateral that you can afford to lose.

It Can Tie Up Your Assets

Another disadvantage of using collateral is that it can tie up your assets.

For example, if you put your home up as loan collateral, you won't be able to sell it until you pay off the loan. 

This can be problematic if you need to access the equity in your home or if you need to sell your real estate for any reason.

It Might Have Restrictions

Finally, it's important to note that some collateral loans might come with restrictions.

For example, some lenders may only allow you to use certain types of assets as collateral, or they may put a limit on the value of the asset you can use as collateral.

Bottom Line

Now that you know how collateral loans work, it's important to weigh up the pros and cons before taking out a loan. Remember, using collateral can help you get a lower interest rate and qualify for a larger loan amount. However, you could lose your collateral if you default on the loan.

Using collateral can be a great way to get a loan, especially if you have bad credit. However, it’s important to remember that if you default on the loan, you could lose your assets, so you should only ever use collateral you’re willing to part with. 

You should also ensure that the value of the collateral is sufficient to cover the amount of the loan, as the lender has the right to seize it if you do not repay your collateral loan on time.

FAQ

Does collateral have to equal the loan amount?

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The collateral does not have to equal the loan amount. However, the value of the collateral must be sufficient to cover the loan amount in case the borrower fails to pay the loan back.

As such, most lenders actually require that the collateral be worth more than the loan amount to give themselves some leeway in case the borrower defaults.

What is the difference between collateral and mortgage?

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Mortgage and collateral are two terms that are often used interchangeably, but they actually have different meanings. 

Mortgages are collateral loans secured by real estate property, while collateral is anything of value a borrower can use to secure a loan.

Do I need collateral for a personal loan?

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You usually don't need collateral for a personal loan. In most cases, personal loans are unsecured loans, which means they aren’t backed by any asset. 

That said, some lenders may require collateral if you have bad credit or if you're borrowing a large amount of money, as there are many collateral loan risks for the lender to take into account.

On the other hand, some online lenders may offer secured personal loans, which means they are backed by collateral. However, these loans are typically only available to borrowers with good credit. 

Can you sell a house that is used as collateral?

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You can sell a house you’ve used as collateral. However, you’ll need to pay off the loan balance first. Once you pay off the loan, you’ll be free to sell the property.

When you take out a collateral loan, the lender will place a lien on the property, meaning that they have a legal claim to the property and can take ownership of it if you default on the loan.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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