Collateral Loans 101: How do These Loans Work?
If you need money for any reason, a collateral loan could be the answer you’re looking for. With this type of loan, you can borrow money by putting down an asset as collateral. Commonly referred to as “secured loans,” collateral loans are considered less risky because your lender can take your pledged assets if you default.
What Is a Collateral Loan?
While the name may not ring a bell, collateral loans are extremely common. Home loans are the most popular type of collateral loan, followed closely behind by car loans. In both cases, a person has borrowed money while securing their loan with an asset. In the case of home loans and car loans, their asset is their home or their car.
Collateral loans are often realized long after the borrower gained possession of their collateral. For example, a borrower may need cash to start their own business and decide to put their home equity and their two paid-off vehicles down as collateral. In another case, a person might put the investment portfolio down as collateral instead.
With collateral loans, the collateral serves as protection for the lender in the case of default. That’s why these loans are called “secured” where other loans without collateral are called “unsecured.”
How Do Collateral Loans Work?
Collateral loans work similarly to traditional loans; after you apply and get approved for your loan, you’ll enter an agreement to repay the money over time. Once you make an agreed upon number of monthly payments and your loan is paid off, the term of your loan ends.
The big difference with collateral loans is that the collateral or “asset” you’ve put down can be repossessed if you default. If you stop paying your home loan, for example, the bank can foreclose on your property and put you out on the streets. The same can be said about car loans; if you stop paying, your lender can show up at your house and haul your car – your “collateral” – away.
To qualify for a collateral loan, you’ll need to prove the value of your assets and be able to prove ownership with a title. Having good credit and a solid work history will also help you qualify, although specific requirements vary by lender.
Types of Collateral Loans
Collateral loans come in many different forms, and extend well beyond simple car loans and mortgage notes. When a person wants to borrow money via a secured loan, many different types of collateral can be considered. Some examples include:
- Real estate (including home equity)
- Natural Reserves such as Oil and Gas
Above all else, your lender wants to get the money you borrowed back. The collateral you offer provides a guarantee that they’ll get some of their funds returned if you default.
It is important to note that most lenders won’t consider the full value of your collateral during the loan process. When you put down collateral that is subject to huge swings or drops in value (e.g. watercraft, stocks, automobiles, etc.), they may only consider half of your collateral’s value in securing your loan.
It’s also important to note that not all collateral loans are the same. Like any other loan, these loans vary dramatically in terms of their interest rate and length of repayment.
As you shop for a secured loan, make sure you understand how each loan works and what your costs will be over time. Not only should you consider each loan’s annual percentage rate (APR), but you should check for additional fees and compare repayment plans. Strive to pay the lowest interest rate possible while choosing a loan with the lowest fees. Also make sure you can easily afford your new loan’s monthly payment before you sign on the dotted line.
How to Borrow Money Without Collateral
Borrowing money without collateral works similarly to taking out a collateral loan. With an unsecured personal loan, you can borrow money without putting down your own assets.
The downside with unsecured personal loans is that you generally need good credit to qualify. And since you’re not putting down collateral, you’ll need to prove your ability to repay with a proven history of work and income.
Just like collateral loans, you can use personal loans for any reason unless your lender sets guidelines on how the money should be spent. Popular reasons for personal loans include home remodeling projects, consolidating debts, and covering big expenses, although there are plenty of other times an unsecured personal loan makes sense.
Collateral loans use your assets for security, but they’re not all the same. Make sure to compare loans among different lenders to find the best loan for your needs. Also remember you don’t have to put down collateral in certain cases. If you can qualify for an unsecured personal loan, you can get the money you need without putting your assets at risk.