There are two types of personal loans: secured loans and unsecured loans. You might have used one or both before, like a secured home equity loan or an unsecured credit card. Both can be used as a financial resource for a variety of reasons, such as funding a vacation, car purchases, and home renovations.
Collateral is an object you provide a loan lender to ensure that you repay the loan. For instance, you might use your home’s deed as collateral for a home equity loan or your car for an auto loan. Some loans don’t require collateral, while others accept different forms of collateral.
- Common types of collateral
- How does loan collateral work?
- Pros and cons of using collateral for a loan
- How to avoid loan collateral
Common types of collateral
The Federal Deposit Insurance Corporation, or FDIC, defines collateral as an asset you own, such as your:
- House
- Car
- Cash
- Boats
- CDs/stocks/bonds
- High-priced items like jewelry, antiques, and collectibles
Some of the best personal loans are secured through specific types of collateral. However, a lender may also let you put your car or home down as collateral for a personal loan that you use for unrelated reasons.
How does loan collateral work?
When a lender extends a loan to a borrower, they risk not getting repaid in full. Collateral protects the lender by allowing them to withhold an object of significant value that the borrower owns. When you repay your loan, the lender no longer keeps your collateral.
If you do not repay your secured loan, this is called defaulting on the loan. The lender can then keep your collateral. In the case of a mortgage or home equity line of credit (HELOC) loan, they foreclose on your house. For auto loans, they repossess your car.
Depending on the value of the object and the amount of the loan, you also may need to pay any balance remaining if the collateral doesn’t repay the debt in full.
Secured vs. unsecured loans
Personal loans fall into two general categories: installment loans and revolving loans. Both revolving and installment loans may be secured or unsecured.
- Installment loans provide you with a single lump sum which you repay in predetermined payments for a set time. Some examples include student loans and mortgage loans.
- Revolving loans allow you to keep borrowing money up to a certain dollar limit. A credit card is a simple example: you can use your credit card as many times as you want until you hit your credit limit. A HELOC is another example.
Unsecured loans only require approval for funding. For instance, you can apply for a credit card and begin using the funds once you’re approved. Your written promise to repay your balance is all that’s required; these creditors will charge you for not repaying your balance on time via late payment fees or interest rates on carried-over balances.
Secured loans require collateral for funding. Collateral acts as a physical promise that you’ll repay your personal loan — if you don’t, you allow them to keep the collateral. Two examples of secured loans are mortgage loans and auto loans.
Because unsecured loans do not use collateral, the lender may view it as a riskier loan than a secured loan. To compensate for the risk, they’ll likely charge a higher interest rate for an unsecured loan than for a secured loan. The rate hike may seem minimal, but consider how much the cost of a secured loan could differ from an unsecured loan.
Let’s pretend two $50,000 personal loans each have a 5-year term that you’d repay in equal monthly payments. The secured loan has a 5.00% interest rate. The unsecured loan has a 10.00% interest rate. Here’s what you’d pay:
- Secured: $943.56/mo | $6,613.70 interest costs | $56,613.70 total
- Unsecured: $1,062.35/mo | $13,741.13 interest costs | $63,741.13 total
Although the monthly payment only increases by approximately $100, you’ll pay over $7,000 more because of the interest rate increase.
Pros and cons of using collateral for a loan
Although you may have the option to finance a large purchase by putting down collateral on a secured personal loan, you should evaluate the benefits and drawbacks of doing so.
Pros:
- Potentially lower interest rate: The presence of collateral makes the loan less risky for the lender, which may encourage them to lower the interest rate.
- Your credit may be positively impacted: By making on-time payments throughout the length of your loan, you may improve your credit report.
Cons:
- You risk losing your collateral: Inability to repay your loan could lead to you losing your car, investment, or other valuable collateral.
- Your credit may be negatively impacted: If you default on your loan and have collateral like your home foreclosed on, it can have a negative impact on your credit history.
How to avoid loan collateral
It’s natural to have reservations about putting collateral down for a loan, especially if you haven’t been through the process before. With the exception of purchasing a car or a home, the thought of putting collateral down on a personal loan can be stressful. Thankfully, there are options for avoiding collateral.
Depending on the amount you need, you could use an unsecured personal loan or a credit card. Both do not require collateral, though the lender may charge a higher APR as a way to safeguard their risk.
If you need to take out an amount that you can only find from a secured personal loan, ask the lender if borrowers with certain credit histories are exempt from providing collateral. You could improve your credit history within a few months by following these tips from the Consumer Financial Protection Bureau:
- Consistently repay your debts on time: This includes paying your mortgage, car payment, and credit card bills on time every month.
- Maintain a healthy debt-to-credit ratio: Try not to use more than 30 percent of your available credit limit to show that you borrow responsibly. Maxing out your credit cards can actually harm your credit score, even if you repay your balance in full each month.
- Check your credit report for errors: If you find any inaccuracies, notify one of the three main credit bureaus and have it removed.
- Consider how many other credit applications you’ve submitted: Asking for multiple forms of credit within a short period can cause a creditor to think you’re a risky borrower. If you’re in a negative financial situation, seek advice from a licensed credit counselor or another legitimate financial resource that you trust.