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What Are Collateral Loans?
If you’re in need of some additional cash, selling your grandmother’s antique pearls at a yard sale may not be the best way to cover expenses. Fortunately, collateral loans offer a great way to get money from valuables without forcing you to sell them. By understanding how collateral loans work and offering to transfer ownership of your items to a financing company if you don’t fulfill your obligation on the loan, you will be more likely to get approved for the cash you need to cover your finances.
What is a collateral loan?
When someone is willing to lend you money, they want to be sure that they aren’t losing their money by lending it out. One way to secure a loan (make it less risky) for the lender is to ask for collateral.
What is collateral? Collateral is something valuable that the lender has the right to take if the borrower stops paying. A collateral loan is also known as a secured loan, meaning it is more secure for the lender. If you buy a car using a car loan, the security on the loan is that the lender will take the car if you stop paying them back. In some cases, the valuable object isn’t what is being purchased with the loan. For instance, sometimes a secured collateral personal loan could be secured with the deed or title to a car or a piece of land or a house, proving that the person is so serious about paying back the loan that they’d risk this other valuable property for it.
What you need to know about collateral loans
Collateral loans help borrowers with damaged credit or borrowers who don’t have the income to support a large unsecured loan. These loans work like other loans, except the borrower is required to sign an agreement that ownership of the property securing the loan will transfer to the lender if the debt is not repaid.
Since the loan is secured by collateral, the lender assumes less risk than with unsecured loans. In an unsecured loan, the bank might never recover any of the funds provided to the borrower if payments stop. With a collateral loan, as a worst-case scenario, the bank can sell the collateral and recoup some of the money.
With this additional security, lenders can lend money to borrowers who would otherwise not qualify for financing. This makes collateral loans ideal for individuals with credit or income challenges. Still, those without access to significant collateral would not qualify for large loan amounts.
What can the collateral be?
Examples of collateral vary depending on the loan. For a personal loan, if you get your secured loan from the same bank where you have a checking or savings account, you can secure your loan with cash from your accounts. A business loan can be secured with, for example, company property like machines or a building. Your house mortgage is typically secured because they can seize ownership of your home if you don’t pay your mortgage payments. The same is true of a car loan, where the car itself is collateral. Rates for these kinds of loan still vary a lot, but they will be lower than unsecured credit like a credit card, where interest rates can be 15-18% on average.
Do all loans require collateral?
Not all loans require collateral, since unsecured loans can be given to those whose credit history, payment history, or assets make the lender sure they will pay back what they owe. Small personal loans, for instance, may not be secured, but if you can provide the deed or title to a piece of valuable property or another form of collateral, you may get a lower interest rate.
Many home mortgages, auto loans, and business loans are secured to the item being purchased with the loan since these items are durable and tend to retain value. Consumer credit and debt, particularly credit cards, don’t carry collateral unless you have a secured credit card, which is backed by a cash deposit that can be taken if you fail to make your credit card payments.
So, should I have collateral? In general, it is helpful to have collateral or a form of secured loan because it increases your lender’s trust in the transaction. You aren’t in danger of losing your collateral unless you are using the loan to purchase something you cannot afford in the long run, which is a separate source of risk.
How to apply for a collateral loan
Speak with your lender about the value of your collateral
Lenders will generally need to offer you a loan smaller than the value of your collateral, on the off chance that it loses value or is hard to liquidate. This may mean the lender needs to see and appraise your valuables in order to be able to offer you a collateral loan. They will usually not keep collateral like cars or homes, but they may keep documentation you would otherwise need to sell the item, such as a title or deed.
Follow application procedures for the loan
While this initial step may be more complex than other lending situations, you’ll otherwise still apply for your loan using documents that prove your ability to pay the loan back, your credit history, and other factors that determine whether the lender is interested in working with you.
Keep the collateral in good condition
A key step in a secured loan is that you work to keep collateral items in good condition, since a reduction in value can negatively impact your loan and, over time, your credit score/history. Most lenders don’t want to have to maintain your car or house, so they are letting you keep it, but if it has a loss in value, that impacts your loan.
If you need to sell your collateral
Your lender needs to know if your collateral is no longer available or in good condition. The situation will vary, but talk to your lender before you move forward with a loan in the first place. What happens if the loan becomes unsecured at some point? For instance, some car loan lenders will require full coverage insurance in order to recoup the value of the car and finish the car loan if you wreck that car. The circumstances are different for each kind of loan.
When your loan is paid in full
Keep good records of your own payments so that, when the loan is satisfied, you can get all rights to your property back. If this means recovering physical items, they should be returned but you might have to make arrangements to get them. For mortgages, for instance, you’ll usually automatically be mailed the deed when you’ve paid off the loan. If for some reason your collateral isn’t released, you should contact your lender.
Pros and cons of collateral loans
Knowing whether a collateral loan is the best solution to your financial needs depends on a number of factors, so it’s important to consider the pros and cons before beginning the application process.
- Easier to get with imperfect credit: Since lenders know they can sell your property if you don’t repay the loan, they are more willing to take a risk on borrowers with less-than-perfect credit history.
- Increased loan amounts:Many borrowers might not qualify for a $50,000 loan, but with an extensive savings account or a CD, it’s easier to borrow higher amounts if needed.
- Lower interest rates than comparable unsecured loans:Since lending companies are assured that they will recover at least a portion of the loan through the collateral, they can offer loans at lower interest rates than comparable unsecured loans to buyers with the same credit scores and income levels.
- Can help build credit:Making payments on time for any type of loan can build credit, but the relaxed credit requirements on collateral loans can help credit-challenged borrowers rebuild their scores quickly.
- Collateral can be lost: The financing company can repossess your collateral if payments aren’t made on time. While the bank is unlikely to resort to repossession the first day a payment is missed, they are within their rights to do so. Continued missed payments can result in the ultimate loss of your property.
- Long application process: Borrowers must provide information on the collateral and sign agreements that the property can be used to secure the loan. Some lenders may also require additional information, such as detailed references, to minimize the risk of default.
Alternative financing options
Although collateral loans can be helpful for rebuilding credit and providing cash flow for borrowers with credit issues, these loans aren’t ideal in every situation. Depending on your financial situation, you may want to consider one of these alternative financing options:
- Use a cosigner:If you’re considering a collateral loan due to credit issues, it can be helpful to add a cosigner with strong credit to your loan application. If a friend or family member with exceptional credit is willing to sign on the loan with you, it can improve the chances that the loan is approved without needing to put collateral on the line.
- Borrow from friends or family:A private loan directly from a friend or family member who has extra funds can help you take care of your finances without the need to secure a traditional loan from a bank or credit union.