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Collateral Loans Unpacked: How They Work, Types, Benefits, and Risks

mattlevy
Matthew Levy Updated: August 13, 2023 • 6 min read
collateral assets for loans

The number of options can be overwhelming when you’re looking for a loan. One type of loan tends to get you the best rates available: collateral loans. While they are also known as secured loans, they are often the most common type of borrowing. We’ll go through what a collateral loan is, how it works, and look at different types, benefits, risks, and more. If you’re looking into collateral loans, you’ll want to read through the guide below.

Collateral helps reduce the lender’s risk, which can help attain better interest rates and terms for the borrower. 

What is Collateral?

Collateral is an asset that a borrower uses as security for a lender when trying to get a loan. It’s used as a guarantee, allowing the lender to assume and seize the collateral if the borrower fails to make the required payments. Collateral helps reduce the lender’s risk, which can help attain better interest rates and terms for the borrower. 

Some examples of commonly used collateral are below:

  • Real Estate: Principal residences, commercial buildings, or even land can be used as collateral for things like mortgage loans or home equity lines of credit (HELOC). 
  • Vehicles: When you buy a new vehicle, you’re often offered financing. The vehicle itself is the collateral for auto loans. 
  • Investments: Stocks, bonds, or other investment accounts can be used to secure personal collateral loans or business loans. 
  • Equipment: Business loans can often use machinery or other significant equipment as collateral.
  • Jewelry or Art: Lenders can potentially accept valuable personal items, like jewelry or artwork, as collateral for loans. 

Collateralized loans are common practice in the lending industry and can be helpful when trying to obtain the best rates possible, depending on your situation. 

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  • Fixed APR: 7.49 - 35.99%
  • Loan Term: 12-84 months
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SoFi
  • APR: 8.99-25.81%
  • Loan Term: 24-84 months
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LoansUnder36
  • APR: 5.99-35.99%
  • Loan Term: 3-72 months
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How Do Collateral Loans Work?

Collateral loans (or secured loans) work by providing a safeguard to the lender in the form of a valuable asset. Here’s a breakdown of how they function:

  • Applying for the Loan: The borrower applies for a loan and offers an asset as collateral.
  • Assessment of Collateral: The lender then has a chance to evaluate the collateral’s value to ensure it matches or exceeds the loan amount. 
  • Loan Approval: If the collateral passes the assessment, the loan gets approved, often at rates lower than the prevailing non-collateralized rate. This is because of the lowered risk due to the collateral backing.
  • Repayment: The borrower then satisfies the contract by making regular payments as agreed to. If the borrower defaults, the lender has the right to seize the collateral in the agreement. 
  • Reclaiming Collateral: If the loan is fully paid off, the borrower reclaims full rights to the offered collateral asset. 

This probably sounds familiar because two of the most common loans, a mortgage and an auto loan, are types of collateral loans. 

Types of Collateral Loans

Here are the most common types of collateral loans:

  • Mortgage Loans: A mortgage loan is secured by real estate, helping you purchase a home or commercial property. 
  • Auto Loans: An auto loan is secured by a vehicle, with the car or otherwise serving as collateral.
  • Personal Collateral Loans: These are secured personal loans using various assets like investments, savings accounts, or other valuable personal items. 
  • Home Equity Lines of Credit (HELOC): If you have built up significant equity in your home (that’s market value minus any mortgage balance), you may be able to use this flexible credit line with your home as collateral. 
  • Equipment Financing: For businesses needing new machinery or technology, the equipment you buy can often be used as collateral to secure the loan. 
  • Savings Secured Loans: Some financial institutions offer loans secured by a savings account, which gives access to funds while continuing to earn interest. 

Choosing the right collateral loan available to you will help you with your financial goals. Take an inventory of the assets you have on hand before seeking a personal collateral loan or business-focused one, and the options you have will expand. 

Why do Lenders Require Collateral?

Lenders may require collateral for certain loans to reduce their risk when providing them. When a borrower offers collateral, the lender has something of value they can take control of and sell for themselves if they default. If you were a financial institution and wanted to lend someone $200,000 for a house worth $350,000, you would have a huge margin of safety when offering this lender money and could give them a better interest rate. This is especially important when lending to borrowers with less-than-perfect credit histories. It can help build trust between the borrower and the lender and align both parties' interests. 

What are the Benefits of Collateral Loans?

Pros of Collateral Loans:

  • Lower Interest Rates: Since the lender’s risk is reduced, interest rates may be more favorable than unsecured loans. 
  • Higher Loan Amounts: Lenders might be willing to offer larger loan amounts when collateral is involved, which is beneficial for significant financial needs. 
  • Easier Approval: With the collateral backing, even borrowers with lower credit scores can facilitate a loan approval. 
  • Flexible Terms: Collateral loans can often be customizable repayment terms, giving borrowers more control. 
  • Potential Tax Benefits: There are possible tax benefits depending on the collateral and loan purpose. 

What are the Risks of Collateral Loans?

Cons of Collateral Loans:

  • Risk of Losing Collateral: If you default on the loan, you could lose the asset used as collateral, whether it’s a car, home, or valuable property. 
  • Potential Fees: Additional costs like appraisal fees, insurance requirements, or prepayment penalties may apply. 
  • Effect on Credit Score: If you miss payments or default on the debt, it will negatively impact your credit score, which can affect your future borrowing. 
  • Possible Reduced Financial Flexibility: Pledging an asset as collateral might limit your ability to use the same asset for other financial opportunities or needs, as it will already have been collateralized. 
  • Stringent Repayment Terms: Failure to follow the specific terms of the loan agreement comes with consequences, including the lender's request for immediate repayment. That would be outlined in the loan conditions, so read the fine print!

How to Get a Collateral Loan

There are several steps in obtaining a collateral loan:

  1. Identify Collateral: Decide on what asset you would like to use as collateral. 
  2. Meet Requirements: Ensure you meet the lender’s credit score and income requirements.
  3. Apply: Complete the lender’s application process, and provide the necessary documents. 
  4. Understand Terms: Review interest rates and terms of the loan before agreeing. 

Alternatives for Collateral Loans

Collateral loans aren’t the only option for borrowers. Some of the more common alternatives include:

  • Unsecured Personal Loans: These don’t require collateral but often come with higher interest rates. 
  • Credit Cards: These are suitable for short-term financing but are not recommended for longer loans, as they usually have extremely high-interest rates. 
  • Peer-to-Peer Lending: Platforms are growing to allow borrowing from individual investors online. Ensure you do your due diligence before entering into any loan. 
  • Government or Non-Profit Programs: Certain institutions may offer loans without collateral for specific purposes, like education (student loans) or small business support. 

Conclusion

Collateral loans offer a way to access funds by leveraging assets like property or vehicles. While you likely can get lower interest rates and favorable terms, there are risks, like the potential loss of the collateral. Ensure you do your homework, and consider all of your alternative options before entering into a collateralized loan obligation. Once you understand what is a collateral loan, how it works, and what it entails, you’ll be empowered to make a well-informed decision. 

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FAQ

Is collateral good for a loan?

Yes, collateral is good if your credit needs work.

Do banks always ask for collateral?

Yes, lenders ask for collaterals in the case of a secured loan.

Is collateral better than credit?

A collateral loan can offer lower interest rates or larger loan amounts.

What are different types of collateral?

accounts receivable, inventory and other tangible assets such as real estate, machinery and equipment

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mattlevy
Written by Matthew Levy

Matthew is a freelance financial copywriter with 14+ years in financial services. He holds a Bachelor of Science degree in Economics with business and finance options and is a CFA Charterholder. He is from Vancouver, Canada, but writes from all over the world.