What are collateral loans?

A collateral loan is an installment loan backed by an asset, such as a car or a home. If you apply for one, lenders will consider the fair market value of the asset you're pledging in addition to factors like your income and credit to determine how much you qualify to borrow and at what rate. But if you miss too many payments, the lender can seize your asset to recoup its loss.

As a result, collateral loans can be easier to get than unsecured alternatives and may offer lower rates. Here's a closer look at how collateral loans work and what you should know before getting one.

What is collateral?

Collateral refers to the property you pledge to get a secured loan. For example, in the case of a mortgage, your home is the collateral. With an auto loan, it's your vehicle. However, collateral doesn't always have to be the asset you're financing. For example, some personal loan lenders offer secured personal loans and allow you to pledge a variety of assets you already own, such as a vehicle, boat, or bank account.

How do collateral loans work?

Collateral loans provide a lump sum upfront that you repay, plus interest and fees, typically through fixed payments over a set term. However, the amount you can borrow, your loan costs, and your loan term are based on the fair market value of your asset - in addition to factors like your income and credit. Lenders will typically appraise your collateral during the application process to determine its value and if it qualifies.

While the collateral secures the loan from the beginning, it stays in your possession. The lender can only take action to seize and sell it if you breach the contract and cause the loan to go into default. If you pay everything on time and as agreed, you'll keep your collateral and can enjoy the perks of better rates and terms or easier qualification.

Secured vs. unsecured loans

A collateral loan, also known as a secured loan, is a loan that requires the borrower to pledge collateral to qualify. In contrast, an unsecured loan doesn't require any collateral. You can get approved based solely on factors like your income, employment situation, credit score, and credit history.

Since collateral isn't pledged on unsecured loans, they may have higher interest rates or be harder to qualify for with bad credit or fair credit. Personal loans are often unsecured.

Different types of collateral loans

Collateral loans come in many forms. Here are some of the different types you can find on the market.

Secured personal loans

Best for: Financing a variety of miscellaneous personal expenses fast

Secured personal loans are installment loans secured by collateral that can be used for a wide range of personal expenses. Lenders vary in the collateral they'll accept but may, for example, allow you to pledge vehicles owned outright, home fixtures, and savings accounts. Secured personal loans may be available with seven year repayment terms, depending on the lender, money is provided upfront, and loans can be approved and funded within days. Loan amounts may depend on the asset you're securing the loan with.

Common uses of secured personal loans include debt consolidation, vacations, weddings, funerals, moving, emergency expenses, and medical bills.

Secured personal loan lenders

Vehicle loans

Best for: Financing the purchase of a vehicle.

Vehicle loans are installment loans secured by the vehicle they're used to purchase. You can find these from most banks, credit unions, non-bank lenders, and car dealerships. They often require a down payment, and the loan amount is determined by the vehicle's cost. Borrowers typically do not take possession of loan funds pre-purchase.

Auto loans average around five and a half years in length, according to Federal Reserve data, though longer-term auto loans are becoming more popular.

Mortgages

Best for: Financing the purchase of a home.

Mortgages are secured installment loans that are used to buy homes. Mortgage lenders often require a down payment which can range from 3% to 20%, along with closing costs that range from 2% to 6% of the loan amount. They are typically either 15 or 30 years in length.

You can use a mortgage to purchase a first home (your primary residence), vacation homes, and investment properties. One of the biggest advantages of mortgages is that you can typically deduct the interest you pay on your taxes, thereby reducing your housing costs.

Home equity loans

Best for: Financing home improvements or large personal expenses.

Home equity loans allow homeowners to borrow against a portion of the equity they have in their homes. Most lenders allow you to borrow up to 80% or 85% of your home's value, in total. For example, if you have a home worth $500,000, you could potentially have up to 85%, or $425,000 mortgaged. So, if your current mortgage is $350,000, you could borrow up to $75,000 with a home equity loan.

These can be helpful if you need to borrow a large amount of money for a personal expense or project.

Secured business loans

Best for: Financing business growth and expenses.

Secured business loans refer to installment loans secured by business assets, such as vehicles, equipment, or accounts receivable client invoices. These can be a helpful solution for businesses looking for capital to help them grow. They offer the perks of keeping your personal and business finances separate, and tax deductibility for interest expenses.

Pros and cons of collateral loans

Not sure if a collateral loan is right for you? Here are the main pros and cons to weigh.

Pros

• Lower interest rates: The presence of collateral lowers the risk for the lender which often results in a lower interest rate than unsecured alternatives.
• Lower fees: The reduced risk can also lead to lower fees.
• Larger loan amounts: Collateral can provide lenders with the backing they need to lend larger loan amounts.
• Flexible eligibility requirements: Collateral can also enable lenders to be more lenient with their eligibility requirements.

Cons

• Puts collateral at risk: Secured loans put your pledged collateral at risk. If you miss payments, your lender has the right to seize and sell it.
• Longer application process: Verifying and appraising collateral can add extra steps and time to the application process.
• Remaining balance: The collateral may not cover the full amount you owe. In that case, you're still responsible for the outstanding balance.
• Closing costs: Loans backed by your home may come with expensive closing costs.

How to apply for a collateral loan

1. Choose a loan type: The first step is to decide on the type of collateral loan you want and need. If you're buying a house, it'll be a mortgage. If you need funds for a variety of personal expenses, it may be a home equity loan or a secured personal loan.
2. Check your credit: Before you begin shopping around, check your credit reports on a site like AnnualCreditReport.com. Your credit plays a large role in the approval process, so you want to make sure it's in the best shape possible. Dispute any errors and look for quick boost opportunities.
3. Shop around: With your credit in good shape, start shopping around for lenders. Make a shortlist of those that look like a good fit, and request quotes.
4. Compare quotes: Once you've collected quotes from your shortlisted lenders, compare them side by side. Review factors like the loan amount, APR, fees, loan term, monthly payment amount, and overall cost.
5. Apply: If you want to move forward with a quote, notify the lender. You'll often need to answer additional questions, provide documents to verify your claims, and allow a hard credit check.

Once you've submitted your application, the lender will review it and your collateral to decide if you're approved, at what rate, and for how much. The process can take a month or more for mortgages and home equity loans.

Collateral loan rates

The interest rates on collateral loans vary by lending institution, loan type, and each applicant's personal details, but here's a look at the average rates broken down by loan type, according to the NCUA.

Note: For contrast, the current average rate on an unsecured personal loan is 15.62%.

FAQ

What happens if you can't repay a collateral loan?

If you can't repay a collateral loan and it goes into default, the lender can seize and sell the collateral you pledged to recover the amount you owe. The default will also typically be reported to the consumer credit bureaus which can negatively impact your credit for seven years. If you foresee missing a payment, it's best to contact your lender as soon as possible to try and work out a payment arrangement.

How hard is it to get a collateral loan?

Getting a collateral loan is typically easier than getting an unsecured loan due to the presence of a valuable asset. Lenders have direct recourse in the event of a default which reduces their risk. However, the specific eligibility requirements vary by loan type and lender.

What can be used as collateral for a personal loan?

Lenders vary in the types of personal loan collateral they accept. To find out what's allowed, you'll have to check with the lenders you're considering. For example, OneMain Financial accepts cars, trucks, motorcycles, and other titled vehicles like boats that you own outright. On the other hand, Best Egg allows you to pledge fixtures in your home.