What are collateral loans?

There are times in life when a loan can make all the difference. But if you don’t have great credit, it can be hard to qualify for one. And raising your credit score can take more time than you have. So what do you do? One option is to take out a collateral loan, which is a loan secured by a valuable asset like your car, home, or savings account. 

Learn how collateral loans work and what to consider, plus where to get one if you decide it’s a good option.

How do collateral loans work?

Collateral loans, also known as secured loans, are loans that require some form of valuable collateral — such as a home, car, savings account, or stocks — in order to qualify. When you take out this type of loan, you’re essentially promising the lender that if you are unable to pay back the loan, it will get the collateral. Some of the most well-known loan types are collateral loans, such as mortgages or car loans.

Because they rely on collateral, it can be easier to qualify for this type of loan if you have fair or poor credit. Even if you have good credit, you could get a lower rate with a collateral loan than you would with an unsecured loan. This is because there’s more risk for a lender on an unsecured loan. (Unsecured loans don’t require collateral.)

When you apply for a secured loan, the lender will generally review your financial profile, including your credit history, and will also need to verify the value of the item you’re using for collateral. If you’re approved and agree to the loan, the lender would place a lien on the item you put up as collateral, which would stay in place until the loan is repaid.

Different types of collateral loans

There are many types of secured loans, each with their own rules and terms. Some common types include:

• Mortgages: With this type of loan, your house is used as collateral, which means the lender could foreclose on your home if you stop making payments. Mortgages are typically available with 15- or 30-year terms. The average rate on a mortgage loan was 6.78% as of July 2023, according to Federal Reserve data.
• Home equity loans: Home equity loans also use your home as collateral, and may be referred to as a second mortgage. These loans involve borrowing against your home’s equity, and are often used to finance large expenses, like home renovations. Home equity loan rates average around 8.5%, according to Bankrate national rate data.
• Auto loans: An auto loan uses your vehicle as collateral and is repaid over a term up to 6 years, in most cases. Average rates on new car loans were just under 8% in May of 2023, according to Fed data.
• Personal loans: Secured personal loans are a form of personal loan that use collateral. Unlike a mortgage, but like a home equity loan, you can use the proceeds for a range of purposes, such as consolidating debt and funding large purchases or events. Loan amounts are available from a few hundred dollars to over $100,000 and repayment terms generally range from 1 to 7 years. Annual percentage rates (APRs) on personal loans vary widely, from around 5% to 36%, but may be on the lower end if you secure the loan.

Pros and cons of collateral loans

While collateral loans have several benefits, it’s important to consider the downsides as well before choosing this type of loan.

Pros

• Lower interest rates: Since your lender can take the collateral if you don’t repay, collateral loans are a lower risk to lenders than unsecured loans. For this reason, they often carry lower interest rates.
• Larger loan amounts: Because they’re secured by collateral, lenders may consider larger loan amounts less risky on collateral loans.
• Higher chance of approval: If you don’t have good credit, it might be easier to qualify for a loan if you secure it with collateral.
• Longer repayment terms: Collateral loans often have longer repayment terms, which can reduce your monthly payment relative to a shorter repayment term.

Cons

• Could lose the collateral: The biggest drawback to collateral loans is that you risk losing the asset you pledged to secure the loan. If you can't repay, the lender can take the collateral. If that collateral is a house or car, for example, that could leave you in an extremely difficult situation.
• Potential to overborrow: Because collateral can secure larger loan amounts, you might be tempted to borrow more than you actually need or can afford to repay.
• You need collateral: If you don’t have a valuable asset, like a car, home, or savings account, you won’t be able to get a collateral loan. Even if you have a valuable asset, the loan amount may be limited by the amount of equity in the asset.
• Complicated process: Since the lender needs to verify the value of the collateral, secured loans can be more time-consuming and complicated than getting an unsecured loan.

“The downside to these loans is the potential to lose the asset you put up as collateral,” said Markia Brown, a certified financial education instructor and registered financial associate at Money Plug, LLC. “Or worse, if the item doesn't cover the total amount owed after it is sold, you would then lose the item and have to pay the remaining balance.”

How to apply for a collateral loan

There are seven key steps in the secured loan application process that you’ll need to complete:

1. Figure out your loan amount needs: It’s always important to avoid overborrowing, since it could end up costing you more in the long run. Determine how much you need to borrow and don’t borrow any more, even if you’re approved for a higher loan amount.
2. Check your credit score: Your credit score will help you figure out which lenders you may be able to apply with (if they publish their minimum credit score requirement).
3. Get an estimate for your collateral’s value: Not only will this help you provide accurate information in your application, but it will indicate whether your collateral is valuable enough to be used for the loan amount you need.
4. Prequalify or get pre-approved: If you’re looking for a mortgage, get pre-approved first so you understand your buying power and loan terms. If you’re looking for an auto loan or a personal loan, many lenders will let you prequalify to see what rates and loan terms you’re likely eligible for. Prequalification involves a soft credit inquiry and will not hurt your credit score. Note that a hard credit pull — which does affect your score — will follow when you submit a formal application. Prequalification is not an offer of credit, and final rates may be higher.
5. Compare lenders: Once you’ve prequalified or received pre-approval, review the terms different lenders are offering, including APRs, repayment term lengths, fees (like origination fees) and discounts (like autopay and direct deposit).
6. Submit the application: Once you’ve compared offers and landed on the one you like best, submit a formal application. You’ll need to provide personal information, such as your income, Social Security number, and address. You’ll also need to support your application with documentation like pay stubs, bank statements, or tax returns. The lender will let you know what you need to support your asset’s value.
7. If approved, review and sign: If the lender approves your application, review the loan’s terms to make sure you agree with the final offer. If you do, sign the loan agreement. Depending on the type of loan, you could receive funds within days.

FAQ

Consider these frequently asked questions about collateral loans:

What is an example of a collateral loan?

Types of collateral loans include mortgages, home equity loans, auto loans, and secured personal loans. Each type of loan has its own requirements for collateral. For example, mortgages and home equity loans use your house as collateral, while auto loans use your car.

How hard is it to get a collateral loan?

How hard it is to get a collateral loan depends on the lender. That said, it can be easier to qualify for a collateral loan than an unsecured loan since a collateral loan is less risky for lenders. However, a credit check is still a part of the application process, and having bad credit will likely result in a higher interest rate, if you get approved.

What do you need to get a collateral loan?

To get a collateral loan, you first need to have something valuable to offer as collateral. Some loans have different requirements for the type of collateral you can use. For example, mortgages and home equity loans require that you use your home as collateral. Otherwise, you’ll need to submit your information and supporting documents in an application to the lender.

What can be used as collateral for a personal loan?

It depends on the type of loan, but you may be able to use a home, car, savings account, mutual fund, stocks, or boat. Keep in mind that should you stop making payments, the collateral could be seized by the lender, leaving you without a valuable asset.

Read more:

• How personal loans affect credit score
• Where to get a personal loan
• Best personal loan rates 
• Best emergency loans for poor credit
• Best loans for bad credit
• Best hardship loans for bad credit
• No-credit-check loans