What Is Collateral?

How Does Collateral Work?

By securing a loan with collateral, you're showing the lender you have a personal stake in the loan and good reason to repay it as agreed. For this reason, secured loans are a less risky proposition for lenders. Knowing a loan is backed with collateral to help offset potential losses, lenders are more likely to approve you for a secured loan, usually with lower interest rates or higher loan limits.

Generally, your collateral should have sufficient value relative to the loan amount so the lender can recover some of its losses if you default on the loan. For example, a lender likely wouldn't accept collateral valued at $1,000 for a loan exceeding $50,000.

Understanding the Risks of Collateral

As a borrower, a secured loan comes with a level of risk since the lender can repossess your collateral if you fall behind or default on your loan. For instance, missed auto loan payments could lead to repossession of your car, which a lender may be able to do without advance warning or court proceedings. Similarly, missed mortgage payments could lead to foreclosure, with the lender taking possession of your house.

Before signing loan documents, it's wise to read the contract to understand how many missed payments lead to loan default and when your lender can seize your collateral.

Do All Loans Require Collateral?

Not all loans require collateral. While home and auto loans usually require collateral, many personal loans, personal lines of credit and even student loans do not. While collateral loans carry a certain level of risk to borrowers, they can be beneficial if your credit is below average since they generally offer more favorable rates and terms than non-collateralized loans.

Types of Collateral Loans

Collateral loans, or secured loans, are quite common and come in many forms, including the following:

Mortgage Loans

Generally, you can choose from conventional or government-backed mortgages to purchase your home. But no matter what mortgage loan you choose, the home itself generally serves as the collateral. Remember, if you fall behind on payments and default on your loan, the lender may foreclose on your home to recover their losses.

Home Equity Loans and HELOCs

Home equity loans and home equity lines of credit (HELOCs) are second mortgages that allow you to access some of your home's equity to pay for a home renovation, a large unexpected bill or other expense. Most lenders typically require you to have at least 15% to 20% equity in your home to qualify. While a home equity loan provides you with a lump sum upfront, a HELOC works more like a credit card with a revolving line of credit you can draw on as needed for a certain time period, often 10 years. In either case, you could lose your home if you miss too many loan payments.

Auto Loans

Auto loans are another common form of collateralized loan. Whether you finance your car through a bank, credit union or dealership, the vehicle typically serves as collateral for the loan. The lender can repossess the vehicle without notice if you fail to repay your car loan.

Secured Personal Loans

Personal loans can be used for all kinds of purposes, such as home renovations or consolidating debt. Most are unsecured, meaning they're not backed by collateral. But some lenders offer secured loans, and you can typically use your car, savings account or home as collateral. But remember, you could lose it if you're unable to repay the loan.

Secured Credit Cards

Getting a secured credit card is a smart credit-building strategy for those with low credit scores or short credit histories. When you apply, you'll pay a deposit that's generally the same as the line of credit you'll receive. That deposit functions as collateral, and you'll lose it if you stop making payments on your card.

What Can I Use as Collateral on a Loan?

Lenders accept many different types of collateral to secure your loan. Here are some of the most common forms of collateral:

• Real estate: Generally, any home, property or other form of real estate you own can serve as collateral.
• Vehicles: When you finance a car, the vehicle you're purchasing typically serves as collateral for the auto loan. You can also use a vehicle you own as collateral for a secured personal loan, such as a car title loan. You may need to own the vehicle outright to qualify, and the lender may max your loan limit at 50% of the vehicle's value.
• Investments: Investment accounts are another common form of collateral, often used to guarantee securities-based loans. In the past, these loans were only available to borrowers with high net worth, but now they are offered to those with smaller portfolios. Lenders offer these loans as installment loans or lines of credit, with loan amounts between 50% and 95% of the value of your assets. Typically, lenders don't accept cash in a 401(k) or individual retirement account (IRA) as collateral.
• Cash: You can often offer up cash in a savings or certificate of deposit (CD) account as collateral on a personal loan. You may be eligible for a loan from the same bank that holds your savings, CD or another deposit account. Your lender may approve you for an amount equal to your savings, thereby insuring the debt. By paying the loan as agreed, these cash-secured loans can be a useful tool to build credit.
• Personal property and valuables: Most assets or personal property can be used as collateral, including jewelry, fine arts, collectibles and precious metals. Before proceeding, understand the value of your assets and the potential risks you could face. For example, let's say you secure a loan with your collection of fine art. Not only can the lender sell your art to recover losses from a loan default, but they could also demand additional payment if funds from your art sale aren't enough to cover their losses.

Pros and Cons of Collateral Loans

As with any financial product, consider the advantages and disadvantages of collateral loans before signing your name for one.

Pros of Collateral Loans

• Can help you get approved for credit: Secured loans are a great option for borrowers with short credit histories or poor credit scores. Adding collateral to the loan reduces the lender's risk, which consequently improves your odds of approval.
• May receive lower rates and better terms: Lenders often extend more favorable rates and fees on secured loans than on unsecured ones since these loans carry less risk.
• Could qualify for larger loan amounts: Even with excellent credit, you might consider securing a loan with collateral. You may qualify for a higher loan amount since the lender will be more confident it can recoup its funds if you default on the loan.

Cons of Collateral Loans

• Risks your collateral: The obvious downside of collateral loans is the risk of losing your collateral if you fail to pay your loan. Losing assets such as a home or car can have a catastrophic impact on your finances and well-being. As such, it's wise practice never to borrow more than you need and make sure you can comfortably afford the payments of any loan you're considering.
• Approval timeline could be longer: Some types of collateral require more time to process, which could extend your loan approval process. For example, if you're securing your loan with jewelry, fine art or collectibles, the lender will likely want to appraise those items, which could delay the processing and funding of your loan.
• Could harm our credit: Foreclosures, repossessions and other derogatory marks can remain on your credit report for up to seven years. These negative credit marks can make it difficult to qualify for credit and loans in the future without paying higher interest rates.

How to Get a Loan Without Collateral

Mortgages, auto loans and other loans require collateral. However, you can take out unsecured loans, such as a student loan or personal loan, without collateral. Unsecured credit cards don't require a deposit as collateral like secured cards do. But without an asset to guarantee the loan, unsecured debt generally carries higher interest rates and may be harder to get. You'll likely need strong credit or a cosigner to qualify.

If your credit is less than ideal, consider pausing your loan search and taking steps to quickly improve your credit. Two best practices to build credit are to consistently make on-time payments and pay down your debt balances. That's because payment history and credit usage account for 35% and 30% of your FICO^® Score^☉ , respectively. Additionally, it's generally wise not to take out new credit shortly before applying for a new loan. Not only can the hard inquiry into your credit temporarily drop your score, but lenders may question if you're relying too much on credit.

Check Your Credit and Track Your Progress

If your credit is below average, you may only qualify for loans requiring collateral. Before you apply for a new loan, you might consider checking your Experian credit report and credit score for free to see where your credit stands. Then, take steps to address any potential issues you spot in your credit report and improve your credit score.

You can also track your credit building progress with free credit monitoring to see how your actions impact your progress.