What Does Collateral Mean And How Does It Work?

There are two primary categories of loans: those secured by collateral and those that are not.

Most large loans are secured by an asset, like your home or car, that the lender can claim if you stop making payments. These collateral loans usually have lower interest rates because they’re less risky for lenders.

But, there are risks for you associated with a collateral loan. If you don’t repay it on time, you risk losing your home, car, or whatever asset you used as collateral. Read on to learn what collateral is and how to get a collateral loan.

Collateral Meaning

Financial institutions define collateral as an asset you pledge to secure a loan. If you default, the lender can seize this collateral to recover the outstanding balance. Common examples of collateral include your home, car, land, or other valuable property. Loans backed by collateral usually have lower interest rates since it reduces the lender's risk.

In contrast, unsecured loans don’t require collateral, so the lender cannot claim specific assets if you fail to repay. Because of this increased risk, unsecured loans typically have higher interest rates.

The purpose of collateral is to encourage responsible borrowing while providing a security measure for lenders. Because collateral decreases risk, borrowers can often secure larger loans at lower interest rates, making this financing option ideal for significant purchases. Unfortunately, if you don’t repay the loan, the lender can seize your asset, so careful financial management is critical.

Examples Of Collateral

To understand what collateral is, it’s helpful to know that lenders use several types of assets as collateral.

• Real estate: Property, such as a home, commercial real estate, and land, are commonly pledged as collateral. Real estate typically has significant monetary value, allowing borrowers to secure larger loans.
• Cash: Cash deposits or savings accounts can serve as collateral for loans. Lenders may hold some of your cash as security, making this a straightforward option for securing financing.
• Vehicles: Lenders often accept cars, trucks, and other vehicles as collateral.
• Investments: Stocks, bonds, and mutual funds can also be used as collateral. Borrowers can access loans without needing to sell their assets by using investments to secure loans, but lenders often require a margin account.
• Equipment: Using equipment, such as machinery or computers, as collateral is common for business loans, allowing companies to leverage their assets for additional financing.
• Inventory: Similar to equipment, Inventory can also be used as collateral to secure business loans.

Types Of Collateral Loans

When considering collateral loans, it’s helpful to understand the various types of loans that utilize collateral to secure financing and how they function.

Mortgage Loans

Mortgage loans are secured by the purchased property, which serves as collateral. When you take out a mortgage, the lender holds a lien on the property, meaning they can foreclose it if you default on your payments. The home itself secures the loan amount, allowing borrowers to access significant sums for purchasing real estate.

Auto Loans

Car loans are another type of secured loan where the vehicle you purchase acts as collateral. When you finance a car, the lender retains ownership until you pay the loan in full. If you don’t make the payments, your lender can repossess the vehicle to recover losses.

Home Equity Loans And HELOCs

Home equity loans and home equity lines of credit (HELOCs) allow homeowners to borrow against the equity they have built up in their properties. A home equity loan gives you a lump sum to repay over a fixed term, using your home as collateral. In contrast, a HELOC provides a revolving line of credit, allowing you to borrow up to a set limit as needed.

While both options utilize your home as collateral, the primary difference between home equity loans and HELOCs is how you access the funds and the repayment terms. Home equity loans generally have fixed interest rates, making monthly payments predictable. However, HELOCs typically have variable rates, which can fluctuate over time.

Secured Personal Loans

Secured personal loans require using something valuable, like a car or savings account, as collateral. Personal loans can be used for a variety of purposes, such as debt consolidation, large purchases, and home improvements.

Secured Credit Cards

Most credit cards are unsecured, so the bank has no collateral to claim if you miss a payment. Instead, they might increase your interest rate or hit you with late fees. But, a secured credit card works differently. When you open the account, you make a cash deposit with the bank, which is both collateral and your credit limit.

The bank can use your deposit to cover the balance if you fall behind on payments. Secured credit cards are easier to qualify for, especially if you have a low credit score. By consistently making on-time payments, you can improve your credit score and eventually qualify for an unsecured card.

Pros And Cons Of Collateral Loans

How To Get A Collateral Loan

Securing a collateral loan involves a few essential steps to ensure you get favorable terms and avoid any issues.

1. Check Your Credit Score And History

Reviewing your credit score and history before applying for a collateral loan is helpful. Although collateral reduces the lender’s risk, your credit score can still affect the loan’s interest rate and terms. A higher score might give you access to better rates, while a lower score could lead to undesirable terms.

You can use AnnualCreditReport.com to access free copies of your credit reports from the three major credit bureaus—Experian™, Equifax® and TransUnion®. Reviewing your credit report also allows you to catch any errors that might hurt your chances of getting approved for a loan.

2. Shop Around For Loans And Get Preapproved

It’s essential to shop around for the best rates and terms. Different lenders can offer varying interest rates, fees, and loan conditions, even for the same type of collateral. Comparing offers will help you secure more favorable terms, potentially saving you money over the life of the loan.

Getting preapproved is another smart move. Preapproval gives you a clearer idea of the loan amount, interest rate, and repayment terms you're likely to qualify for, all without affecting your credit score. It also makes you a more attractive borrower to lenders since you’ve already taken the initial steps to qualify for a loan.

3. Compare Loan Offers

After receiving preapproval from various lenders, comparing your loan offers is crucial. Look closely at key factors such as interest rates, repayment terms, fees, and any penalties for early repayment. Understanding these details can help you make a more informed decision and ensure that you select a loan that best meets your financial needs and goals.

4. Gather Your Documentation And Apply For The Loan

The necessary documentation typically includes proof of income, credit history, and details about the collateral you intend to use. You might also need an appraisal. Organizing these documents can streamline the application process and increase your chances of getting approved. Be aware that the approval process might be lengthy.

5. Receive The Funds

You can now access the money you loaned, which is known as loan disbursement. It marks the release of loan funds, when loan interest starts to accrue, and your responsibility to repay the loan.

The Bottom Line

When buying something big, like a home or a car, you usually apply for a secured loan. These loans are appealing because they often come with lower interest rates and larger loan amounts than unsecured loans. However, it’s important to make your payments on time. If you don’t, you risk losing your collateral.

Want to learn what collateral-backed mortgage rates you qualify for? Start the mortgage approval process today!