Collateral is an asset pledged by a borrower, to a lender (or a creditor), as security for a loan. Borrowers generally seek credit in order to purchase things – it could be a house or a car for an individual, or it could be manufacturing equipment, commercial real estate, or even something intangible (like intellectual property) for a business.
In this article, we’ll guide you through the step-by-step process of obtaining collateral loans and all share other things you need to know about collateral loans.
What Are Collateral Loans?
A collateral loan often referred to as a secured loan is that type of loan guaranteed by something you own. It is a type of loan that allowed the borrower to pledge any asset to seek the loan.
The amount of money awarded is usually dependent on the type of collateral tendered. According to Bajajfinserv, this type of loan is relatively risk-free for the lender as they can liquidate the assets of the borrower in a case of default. As a result, borrowers can lend a high amount of loans for a low-interest rate.
How Does Collateral Work?
With a collateral loan, you can expect to receive more attractive loan terms than with an unsecured loan. This might comprise a lower interest rate, a larger loan amount, or a longer loan term.
Before a lender endorses a collateral loan, they will take the time to determine the value of your collateral. To do this, they’ll consider the fair market value of what you own, or in the case of a mortgage, the appraised value of your home. Then they’ll determine the size of your loan by offering you a percentage of what your collateral is worth. If it is a mortgage loan, a lender will consider factors like the potential resale value of the home you’re considering, and the surrounding neighborhood.
With a mortgage, the value of your collateral is directly reflected in the loan-to-value ratio (LTV) a lender will assign to your loan. When applying for a loan, lenders often quote an acceptable loan-to-value ratio (LTV). For example, if you borrow against your house, lenders might allow an LTV of up to 80%. In that case, if your home is worth $100,000, you could borrow up to $80,000.
This means, that the higher your LTV, the more you can expect to pay in interest costs and closing costs. You’ll also need a larger down payment.
Please note: an asset becomes collateral security when a lender registers a charge over it, either by using a fixed or a floating charge. These charges are also known as liens.
Charges are filed with a public registry, which differs by jurisdiction. The public registry allows stakeholders to see and comprehend who has claims over which assets and in what order those claims were filed.
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Common Types of Collateral Loans
There are different types of collateral loans. Your mortgage, for instance, is a type of collateral loan; if you stop making monthly payments, as a result of the difficulty in working out a mortgage modification with your lender, you may lose your home.
Here are the four categories of collateral loans:
1. Mortgage
One of the most common types of secured loans is a mortgage. Collateral loans on a property are supported by the real estate that you are financing. If you miss payments, the loan can go into default, in which case the lender forecloses on your home and sells it to get back its losses.
2. Home equity loan
Unlike the mortgage collateral loan, a home equity loan is secured by the home’s equity or the difference between the home’s current value and the amount still owed on the mortgage. This type of loan can be seen as a “second mortgage” and allows you to borrow against your equity.
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3. Vehicle loan
If you take out a loan to buy a car, truck, boat, motorcycle, or even a private jet, the vehicle serves as collateral for the loan. Failure to repay the loan, similar to a mortgage, might result in the car being repossessed.
4. Secured personal loan
Personal loans can be utilized for a variety of purposes, including purchasing a large item or consolidating credit card debt.
They are accessible from lenders in both secured and unsecured forms. Putting up collateral on a secured personal loan will get you better interest rates and terms. You can acquire a personal loan with collateral using a number of valuables, including cash, a vehicle, stocks and bonds, jewelry, collectibles, and more.
What Are The Advantages And Disadvantages Of Collateral Loans?
Though using a collateral loan can be an effective way to borrow money, there are some pros and cons attached to collateral loans.
Pros
The major advantages of a collateral loan are:
1. You’re more likely to be approved
If you’re having a tough time getting a loan, perhaps due to credit issues or a short credit history, securing a loan with collateral could help militate your risk as a borrower.
2. You might qualify for a larger loan
Similarly, since you are reducing the lender’s risk by offering up collateral, you might qualify to borrow more than you would otherwise.
3. It provides short-term liquidity
If all of your money is tied up in assets that aren’t easy to convert into cash, such as a home or valuables, a collateral loan can help you secure money without having to go through the cumbersome process of selling those assets.
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Cons
Here are a few disadvantages of collateral loans:
1. You can lose the collateral if you don’t pay the loan back
The biggest risk of a collateral loan is you could lose the asset if you fail to repay the loan. It’s especially risky if you secure the loan with a highly valuable asset, such as your home.
2. It requires you to have a valuable asset
Another potential issue is that you must have something valuable to offer as collateral in the first place. With an unsecured loan, you can borrow money without offering anything in return – except your credit score. If you’re unable to qualify for an unsecured loan, it might be tough to come up with the collateral necessary to secure a loan instead.
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Where To Find Collateral Loans
Most financial institutions offer collateral loans. However, the terms and interest rates might differ. If you’re not sure where to start your search, here are a few types of lenders you should consider:
1. National banks
Large banks are known for their convenience, as they tend to offer the most diverse range of financial services. If you’re currently a customer or there aren’t any other convenient options nearby, borrowing from a national bank can be a suitable option.
2. Community banks
Smaller local banks usually work with local customers. They have to compete with larger banks for business, which means they may offer more competitive terms on deposits and loans. So, if you are looking for collateral loans, a community bank is definitely an option.
3. Credit unions
Credit unions, another type of community financial institution, are member-owned nonprofit financial cooperatives. As a result, they’re also fantastic sites to look for collateral loans with better rates and conditions.
To join a credit union, you must normally reside, work, attend school, or attend religious services within the credit union’s membership area and have a savings or share account.
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4. Online lenders
Lastly, online banks may be able to provide access to loans that are not available locally. Online banks may also be able to lend at lower rates because they operate solely on the internet and have low overhead.
Look for lenders who will enable you to prequalify to see what interest rates and terms you might be eligible for before filing an official application. You’ll be able to know what your alternatives are without having to do a hard credit inquiry.
How To Apply For Collateral Loans
If you think a collateral loan is the right option for you, here are a few important steps to take:
1. Check your credit
Even if your credit isn’t perfect, securing a loan with collateral can help you be approved for a loan. However, in order to acquire the best collateral loan rate and payback terms, you should make sure your credit is as strong as it can be.
You may get your credit reports for free at annualcreditreport.com; review them for any inaccuracies or negative marks that need to be addressed before applying for a loan, such as a late payment.
2. Choose your collateral
The collateral underlying your loan will be the property you’re financing if you’re asking for a home or auto loan. You do, however, have options if you’re taking out a secured personal loan. Determine which assets you have to secure your loan and aim to choose liquid and easily accessible assets, such as funds in a bank account.
3. Gather your documentation
Once you’re ready to apply, it’s helpful to gather all the documents and information for the loan to be processed. Some information you can expect to be asked for includes
- Personal details – your name, birthdate, Social Security number, and driver’s license
- Government-issued identification
- Proof of income and assets – such as W-2 forms, pay stubs, recent tax returns, and bank statements
- List of liabilities – such as existing debt payments, monthly rent or mortgage payments, child support or alimony payments, and other monthly obligations.
4. Look around for the best collateral loan rates.
Before you go through the full application process, it’s important to get quotes from different lenders and compare the collateral loan rates and terms. You can get quotes online, which typically only require a soft credit check and won’t impact your credit.
5. Choose your lender and apply
You can begin the application process once you’ve found an offer that meets your budget and requirements. It’s important to understand that formally asking for a loan will trigger a hard credit check, which will appear on your credit reports. It should, however, only have a transient and minor effect on your credit score.
Can You Borrow Without Collateral?
According to thebalance, if you prefer not to pledge collateral, you’ll need to find a lender that’s keen to approve a loan based on your income and credit scores. Some of the options include:
- Unsecured loans from banks and credit unions, such as personal loans and credit cards.
- Online loans (including peer-to-peer loans) are often unsecured loans.
- Getting a co-signer to apply for the loan with you, puts their credit at risk to help you get approved.
In some cases, like when buying a home, borrowing without using anything as collateral is likely not possible (unless you have significant equity in the home). In other circumstances, borrowing without collateral may leave you with lesser choices and more expensive options.
Common Collateral Loan Rates
Here’s a rundown of the common collateral loan rates as stated on Lendingtree:
| 5 common types of collateral loans | ||
| Loan type | Collateral | Typical rates |
| Residential mortgage | Home | 3% |
| Home equity loan | Home | 3% to 10% |
| Car loan | Vehicle | 4% to 15% |
| Car title loan | Vehicle | 25% per month |
| Personal loan | Savings account or other collateral | 9% to 22% |
FAQs On Collateral Loans
If you don’t have any business assets to secure a loan, you might be eligible for unsecured financing.
Lenders usually prefer assets that are easy to value and liquidate
Collateral loans come with some risk since you could lose the asset you use to secure the loan if you fail to make payments. However, if you’re on solid financial footing, a collateral loan can be well worth it.
A down payment is usually 20% of the total mortgage loan that you are expected to take on. You can use your current assets, like stocks, gold, and other property, to take out a loan to pay your down payment if you need to.
The loan-to-value ratio (LTV) is the amount you’re eligible to borrow divided by the value of your collateral, typically expressed as a percentage.
Conclusion
When it comes to the type of assets you can use as collateral, the easier it is to value and turn into cash, the better for you. Therefore, ensure you make your decisions wisely based on the knowledge of collateral loans.
References
- money.usnews.com – Everything You Need to Know About Collateral Loans
- thebalance.com – Using Collateral Loans to Borrow Against Your Assets
- finder.com – What do lenders accept as collateral for loans?
- lendingtree.com – What Are Collateral Loans and How Do They Work?
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