What Are Collateral Loans and How Do They Work?
A collateral loan is a form of debt that’s secured by a valuable asset. Because the lender takes on less risk with a collateral loan, they often come with lower interest rates than unsecured loans. However, the consequences of not repaying a collateral loan mean you could lose that valuable asset — your car or home, in some cases — so be sure to weigh your options carefully.
What is a collateral loan?
A collateral loan — also called a secured loan — is backed by something you own. Some of the most common types of collateral loans are auto loans and mortgages, though other forms of collateral that can be used include:
- Savings account/certificate of deposit (CD)
- Car or truck
- Boat
- RV
- Piece of jewelry
- Investment portfolio
- Home or other types of real estate
- Insurance policy
A collateral loan can offer lower interest rates or larger loan amounts. In some cases, it may be the only loan option for a borrower who has a poor credit history or too low of an income to qualify for an unsecured loan.
However, if you can’t repay the loan, the lender has the right to seize the collateral. Unsecured loans, on the other hand, are backed only by your promise to repay. Your eligibility and rates are based on the lender’s confidence in your income and credit history.
Pros and cons of collateral loans
Collateral loans may be particularly attractive to consumers with bad credit or without much credit experience at all. However, be sure that the benefits outweigh the risks before agreeing to take on a loan.
| Pros | Cons |
|---|---|
Helps borrowers with below-average credit access financing May offer lower interest rates and larger loan amounts than unsecured loans Helps borrowers build credit and improve their scores | Loan eligibility limited to borrowers with valuable assets Additional red tape during the application process Risk of losing your asset |
How do collateral loans work?
With a collateral loan, you may receive more attractive loan terms than with an unsecured loan, including a lower interest rate, larger loan amount or longer loan term.
Before a lender approves you for a collateral loan, they’ll need to determine how much your collateral is worth by assessing the fair market value of your asset. In the case of a mortgage, this includes the appraised value of your home. The size of your loan will be determined as a percentage of your collateral’s value.
With a mortgage, the value of your collateral is directly reflected in the loan-to-value ratio (LTV) the lender assigns you. In general, the higher your LTV, the more you can expect to pay in interest and closing costs. You’ll also need a larger down payment: For example, if your LTV is 80%, you’ll need to provide the remaining 20% out of pocket.
Where can you find loans with collateral?
If you’re ready to compare secured loans from top lenders, keep in mind that your options depend on the type of collateral you have to offer. Some lenders have limits on the types of assets they’re willing to accept, so be sure to do your research before submitting an application.
- Banks: If you already have an account with a bank, you may be able to get funds on the same day you apply, or the next business day. With car loans, however, watch for potential restrictions on the make, model, mileage or year for the car you hope to buy.
- Credit unions: You’ll likely need to be a member to qualify for a credit union personal loan, but rates are typically lower than bank rates. Annual percentage rates (APRs) for credit unions are capped at 18% by the National Credit Union Administration.
- Online lenders: Many online loan lenders only offer unsecured loans, and you may have to apply for an unsecured loan before you see a secured loan option.
- Auto dealerships: Automakers typically offer loans on new car purchases through their dealerships. In-house financing rates are often competitive with those offered by banks and credit unions, but you’ll need strong credit to qualify for the best rate.
- Pawn shop loans: These short-term loans don’t require a credit check and may provide nearly instant access to cash. However, pawn shop loans are best avoided — they often come with sky-high interest rates and short repayment terms.
Types of collateral loans
There are a variety of types of collateral loans. The following are a few of the most common ones:
Mortgage
With a traditional mortgage, your house is the collateral. If you default, you risk losing your home in foreclosure, which means you’ll no longer own the property.
Home equity loan
As with a mortgage, your home serves as the collateral you’ll need for a home equity loan. This type of loan lets you draw against the equity you’ve built up in your home and receive a lump-sum payment that can be used for a variety of uses, like home renovations.
A home equity loan comes with a fixed interest rate, but you’ll need to keep up with your monthly payments to avoid damaging your credit or losing your home.
Auto loan
Auto loans are secured by the vehicle you plan to buy, like a car or SUV. While there are unsecured car loans out there, the majority are secured by the vehicle because they offer the best interest rates.
If you default on your loan, your lender may repossess your car. However, because cars tend to lose their value so quickly, some lenders may be willing to defer payments or offer loan modification to avoid repossession.
Car title loan
If you need to borrow a small amount of money for a short period of time, this type of loan lets you borrow against your car title. However, it’s best to avoid car title loans since they typically have to be repaid within 15 to 30 days, come with fees and usually carry high interest rates. If you default, the lender can seize your car.
Personal loan
A secured personal loan can be used for almost any purpose, like fixing a home or consolidating debt. As collateral for this type of loan, you may be able to use a personal savings account or CD. But if you default, you risk losing those assets.
What are collateral loan rates?
Collateral loan rates are dependent on the type of loan and the collateral you have to offer. Typically, the more valuable your collateral, the lower the rates you may receive.
| Loan type | Collateral | Typical rates |
|---|---|---|
| Mortgage | Home | Averaging 7.90% APR for 30-year-fixed mortgages |
| Home equity loan | Home | Starting at 7.99% APR |
| Car loan | Vehicle | Starting at 4.50% APR |
| Car title loan | Vehicle | 300% APR |
| Personal loan | Savings account or other collateral | Up to 36% APR |
How do you apply for a loan?
- Check your credit score. As with most loans, borrowers with the best credit scores qualify for the lowest interest rates. Check your credit score before applying to make sure there are no surprises.
- Prequalify with several lenders. Loan features and requirements will vary by lender, so getting prequalified with at least three lenders is the best way to compare secured loans. When you apply for prequalification, the lender will perform a soft credit check, which won’t affect your credit rating.
- Compare offers. After you prequalify, you’ll need to compare offers. Compare factors like APR, loan term, loan amount, fees and restrictions.
- Collect your supporting documents. Lenders will need to verify your income, financial holdings and other types of debt. Be prepared to submit documents like pay stubs, W-2s, bank statements, tax documents and mortgage statements.
- Submit a formal application. After selecting a lender, follow its application process and submit any required documents.
- Receive your money. Some secured loans, like mortgages, can take up to 60 days to close before you receive your funds. Other types of secured loans may close more quickly.
What happens if you don’t repay your debt?
Depending on the lender, if you miss a payment, your collateral loan might be in default after 30 to 90 days. However, most lenders offer a grace period after a missed payment. Your loan might be considered delinquent at that time, but you may be able to work with your lender to come up with an acceptable payment plan before your loan actually goes into default.
If your account continues to be delinquent, you run the risk of losing your asset, depending on the lender, the type of loan and your state of residence. Read the fine print in your contract to understand your loan’s payment obligations and check your state’s laws.
For example, car repossession might occur as soon as you default on your loan, and a lender may not necessarily have to notify you. If you’ve defaulted on your mortgage, the foreclosure process will usually begin three to six months after you first miss a payment, although in some states, lenders may have to take you to court first.