What is a collateral loan and how does it work?

A collateral loan (also known as a secured loan) lets you borrow money using an asset to secure the loan. With collateral backing the loan, lenders reduce their risk and can offer more competitive interest rates. But there are also drawbacks to consider when you put a valuable asset on the line to secure funding.

Here’s what you need to know about collateral loans and what happens when you get one.

What is a collateral loan?

When you’re applying to borrow money, a lender might require you to provide something valuable that can be seized if you’re unable to repay your loan — this is collateral. The asset will be used to pay off your loan if you can’t. 

“A collateral loan is an alternative to an unsecured loan,” says Gladys Castro, a business credit advisor at Accion Opportunity Fund. “Requirements for collateral-based loans vary from lender to lender. In some cases, lenders require collateral even for small loans. Collateral may also help a borrower qualify to borrow a larger amount than if you were to take an unsecured loan without it.”

To obtain a collateral loan, you need to have an asset to secure the loan. For example, this could be a car for an auto loan, a home for a mortgage or even a savings account or certificate of deposit (CD) for a secured personal loan.

How collateral loans work

Getting a loan that requires collateral means you’ll need to agree to give up that asset if you can’t afford to repay your loan or fall behind on payments. For instance, when you take out a mortgage, you agree in your loan terms that if you fail to make payments, your home could be seized and foreclosed on by the lender. Or if you fall behind on auto loan payments, your car could get repossessed.

Note that lenders use collateral strictly as a way to ensure you repay your loan. Once you pay the loan in full, your asset is no longer on the line with the lender.

Pros and cons of collateral loans

Pros

• Can help you qualify for a loan: If you don’t have great credit, using collateral to secure your loan can help you qualify to borrow money. Lenders use your credit score and credit history to determine eligibility, and if those don’t meet their standards, using collateral might help your case.
• Typically have lower interest rates: Secured loans tend to offer lower interest rates compared to unsecured loans. That’s because if you fail to repay your loan, the lender can seize those assets, which makes the loan less risky for the lender. 
• Can have larger loan amounts: Offering up collateral can help you qualify for a larger loan amount, such as on a home or car loan.

Cons

• Risk of losing your assets: If you fall behind on payments or default entirely on the loan, you could end up losing your home, car or other property. 
• May not qualify with collateral requirements: You’ll need property with sufficient value to use as collateral for a secured loan. “During the application process, you may find your valuables are worth less than you anticipated, due to depreciation,” Castro says. [This] may mean you may not qualify for the loan amount you had in mind.”

Types of collateral loans

There are many different types of collateral loans, such as:

• Mortgages. 
• Auto loans. 
• Home equity loans. 
• Secured personal loans. 

Keep in mind that while collateral loans can be easier to qualify for compared to unsecured loans, some come with extremely unfavorable terms. For example, if you need cash and don’t qualify for an unsecured personal loan, you might opt to use your vehicle title as collateral on a car title loan to get the funds you need. 

However, title loans tend to have astronomically high interest rates and very short repayment terms — usually requiring repayment within 30 days. If you don’t repay the loan, your car could be repossessed and sold to repay the debt.

Borrow carefully! Because of their predatory nature, it’s best to treat car title loans and other similar short-term loans (such as pawn shop loans and payday loans) as a last resort. You’ll generally be much better off relying on a traditional personal loan from a legitimate lender, which will come with a reasonable rate and terms.

How to get a collateral loan

If you’re ready to get a collateral loan, follow these steps:

1. Check your credit. Before a lender reviews your credit score and credit history, take the time to pull the report for yourself. Go to AnnualCreditReport.com to obtain a free credit report from each of the three major credit bureaus. You can get free reports once every 12 months. You can also often access your credit score through your credit card issuer or bank.
2. Compare lenders and get pre-qualified. Be sure to shop around and compare your options with as many lenders as possible to find the right loan for you. Consider important factors like interest rates, repayment terms and fees. Many lenders also allow you to pre-qualify with only a soft credit check that won’t hurt your credit score. This will give you an idea of what loan terms you might get approved for. You can also use our personal loan calculator to see what your overall costs could look like with these terms.
3. Have your collateral appraised. Different lenders might appraise your collateral for varying amounts. As you compare lenders, make sure to also ask for an appraisal to see which lender offers you the most for your valuable item. Note that depending on the lender, an appraisal might also be required during the application process.
4. Choose a lender and complete a full application. After you’ve done your research, pick the loan option that works best for you. You’ll then need to submit a formal application. Be prepared to provide any required financial documents, such as tax returns, pay stubs, address verification (like a utility bill) or bank statements. The lender will also perform a hard credit check while analyzing your application.
5. Get your funds. If you’re approved, the lender will have you sign the loan agreement before disbursing the funds to you — often via direct deposit.

Should you get a collateral loan?

You might want to consider getting a collateral loan if:

• You don’t have the funds to pay for something outright, like a car or home, and need to borrow money.
• You compared collateral loans to other types of loans and found that they offer the best possible interest rate, repayment terms and fees.
• You can responsibly repay your loan so that you don’t lose your asset.

However, an alternative might be better if:

• You have other borrowing options that don’t require collateral.
• You can find lower interest rates or better repayment terms elsewhere.
• There’s a chance you might not be able to repay your loan and could face having your assets seized.

Alternatives to collateral loans

If you don’t qualify for a collateral loan or want to look at other options, here are a few alternatives to consider:

Unsecured personal loan

Unsecured personal loans don’t require collateral and are more widely available than their secured counterparts. However, keep in mind that you might need a higher credit score to qualify. Additionally, because unsecured loans are riskier for lenders, they tend to have higher rates and fees compared to collateral loans.

Credit card cash advance

If you need to borrow a small amount of money and don’t think you’d qualify for a collateral loan, you can get a cash advance from your credit card. Note that these tend to have higher annual percentage rates (APRs) than even your regular credit card purchase APR. 

You can also face other fees for cash advances, depending on your card issuer. Additionally, some might require fast repayment, so only go this route if you plan to pay back your advance soon.

Co-signed or joint loan

If you don’t qualify for a loan on your own, you can ask a trusted friend or relative with good or excellent credit to be a co-signer or joint applicant. Having a co-signer or joint applicant can make it easier to get approved and could also qualify you for a better rate than you’d get on your own.

Just be aware that if you can’t repay your loan, a co-signer will be on the hook for payments. A joint borrower, on the other hand, will be equally responsible for repayment from the start of the loan.

Additionally, not all lenders permit co-signers or joint applicants.