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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?
Collateral loans are made to a borrower and secured with some type of property or account as a good-faith promise to repay the loan. For example, when a bank issues a car loan, the loan is contingent on the borrower’s agreement that the car can be sold to recoup the loan if the payments are not made as agreed. Since the borrower offers the property to help secure the lender’s financial investment, this arrangement is also referred to as a secured loan.
What you need to know about collateral loans
Collateral loans are helpful for borrowers with damaged credit or borrowers who don’t have the income to support a large unsecured loan. These loans work much like any other loan, 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 financing company assumes less risk than with unsecured loans. In an unsecured loan, the bank might never recover any of the funds provided to the borrower. 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, banks can lend money to borrowers who would otherwise not qualify for financing. This makes collateral loans ideal for individuals with credit or income challenges, but those without access to significant collateral would not qualify for large loan amounts.
How to apply for a collateral loan
The application process for a collateral loan will vary based on the type of collateral used and the amount of the loan. For example, a mortgage loan uses your house as collateral, and a mortgage application process is considerably more extensive than applying for a small personal loan of $1,000 that is secured by a certificate of deposit or a savings account.
In general, borrowers must gather some documentation, like drivers’ license, state ID, Social Security number and proof of income. They must also provide documentation on the collateral, such as a title or deed for an auto or home loan. If the loan is secured by other personal property, such as valuables, accounts or a life insurance policy, the borrower may be required to provide pictures, registration paperwork or other proof of ownership.
The bank or financing company will then prepare the loan paperwork, gather signatures from the borrower and verify the borrower’s qualifications for the loan, including identity, credit scores, income and ownership of the collateral. Once the documentation has been collected, all of the paperwork will be sent through underwriting, which is a process that financing companies use to evaluate the risk associated with the loan and make a decision on the borrower’s application. Underwriting can take anywhere from a few minutes for small personal loans to several weeks for large mortgage loans. If the loan is approved, the financing company will issue a check for the amount of the loan.
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 co-signer 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.
- Finance with credit cards: If you have available credit on a credit card, using it to meet your financing needs can be a smart financial move with a plan to repay it quickly. Many credit cards offer travel points or other cash-back rewards that can lower the cost of this financing option. Just make sure to stick to an aggressive repayment plan to avoid excessive interest charges.