What Are Collateral Loans and How Do They Work?

Sometimes it’s a lot easier getting a loan when you’re willing to put up some kind of collateral   — like your home, car or grandfather’s Rolex. Loans with collateral helps secure the money you’re borrowing, potentially at lower interest rates. However, a collateral loan could mean yielding a valuable asset if you fail to repay your debt.

But how do collateral loans work? Read to learn how lenders determine the value of your collateral and use it to gauge the size of your loan.

What is a collateral loan?

A collateral loan is often called a secured loan. This means the loan is guaranteed by something you own. And if you can’t pay your loan back, the lender has the right to claim the collateral, whether it’s a…

• Car
• Savings account
• Piece of jewelry
• Investment portfolio
• Home or other real estate
• Insurance policies
• Other valuables

A collateral loan can offer a lower interest rate or larger loan amount than with an unsecured loan like a credit card. In some cases, it may be the only loan option for a borrower who has either a short or unsteady credit history, or whose income is too low to qualify for an unsecured loan.

There are many different types of collateral loans. Your mortgage, for instance, is a type of collateral loan; if you stop making monthly payments — and can’t work out a mortgage modification with your lender — you may lose your home. The debt that comes with unsecured loans, on the other hand, is typically backed only by your willingness to repay, and a lender’s confidence in your income and credit history.

Pros and cons of loans with collateral

How do collateral loans work?

With a collateral loan, you can expect to receive more attractive loan terms than with an unsecured loan. This might include a lower interest rate, larger loan amount or a longer loan term.

Before a lender approves you for a collateral loan, they will take the time to determine how much your collateral is worth. To do this, they’ll consider the fair market value of what you own, or in the case of a mortgage, the appraised value of your home. Then they’ll determine the size of your loan by offering you a percentage of what your collateral is worth. With a mortgage, for example, a lender will consider factors like the potential resale value of the home you’re considering, and the surrounding neighborhood.

With a mortgage, the value of your collateral is directly reflected in the loan-to-value ratio (LTV) a lender will assign to your loan. In general, the higher your LTV, the more you can expect to pay in interest costs and closing costs. You’ll also need a larger down payment. If your LTV is 80%, you’ll know your lender is willing to lend you a substantial amount of money, but you’ll need to cover the remaining 20% out of pocket.

Where can you find loans with collateral?

Banks: If you already have an account with a bank, you may be able to get funds on the same day you apply, or the next business day. With car loans, however, watch for potential restrictions on the make, model, mileage or year for the type of car you hope to buy.

Credit unions: You’ll likely need to be a member of the credit union to qualify, but rates are typically lower than bank rates.

Online lenders: Many online lenders offer unsecured loans only, and you may have to apply for an unsecured loan before you see a secured loan option.

Auto dealerships: Automakers typically offer loans on new car purchases through their dealerships. Rates are often competitive with those offered by banks and credit unions, but you’ll need strong credit to get the best rate.

Storefronts offering pawn shop loans: For one of these short-term loans, you’ll be expected to secure funds in your checking account. Expect sky-high interest rates.

If you’re ready to compare secured loans from top lenders, keep in mind that your options depend on the type of collateral you have at your disposal. Not all banks, credit unions or online companies allow applicants to submit vehicles or homes, for example, as their vulnerable assets.

Some lenders require you to post an in-house savings or investment account as collateral. In this case, if you’re a new customer, you could look into transferring funds from your current bank or credit union.

Top lenders for collateral loans

What are collateral loan rates?

Your collateral loan rates are also dependent on the type of collateral that’s a part of your loan application.

Residential mortgage: With a residential mortgage, your house is the collateral. If you default, you risk losing your home in a foreclosure, which means you no longer own the property.

Home equity loan: As with a mortgage, your home is the collateral you will need for a home equity loan. This type of loan lets you use whatever equity you’ve built up in your home to receive a lump-sum payment that can be used for a variety of uses, like for renovations. A home equity loan comes with a predictable, fixed interest rate, but you’ll need to keep up with payments to avoid damaging your credit or ultimately losing your home.

Auto loan: This type of loan is secured by the vehicle you plan to buy, like a car or SUV. It’s possible to buy a car without worrying about collateral, but most car loans are secured because they offer the best interest rates. In most cases, lenders won’t rush to take your vehicle if you default because cars tend to lose their value so quickly. Instead, they prefer to work with borrowers to possibly ease the loan’s terms and make it easier to repay.

Car title loan: If you need to borrow a small amount of money for a short period of time, this type of loan lets you borrow against your car title, the legal document that proves ownership. These loans typically have to be repaid within 30 days, come with a fee and usually carry extremely high interest rates. If you default, the lender can take your car. You’re likely to be better off taking out a small personal loan or a cash advance from a credit card.

Personal loan: A personal loan lets you borrow money for almost anything, like fixing a home, consolidating debt or paying medical bills. As collateral for this type of loan, you may be able to use a personal savings account or certificate of deposit (CD). But if you default, you risk losing those assets.

How do you apply for a loan with collateral?

1. Check your credit score. As with most loans, borrowers with the best credit scores qualify for the lowest interest rates. Review your score in advance to make sure there are no surprises.
2. Prequalify with several lenders. Loan terms like interest rates can vary a lot according to the lender, so this is the time to compare secured loans.To get an early look at potential offers, see if a lender will prequalify you and do this with at least three lenders. When you apply for prequalification, lenders will do a soft credit check but it won’t affect your credit standing.
3. Compare offers. After you prequalify, you’ll need to compare offers, based on loan terms and also lender fees.
4. Collect your supporting documents. Lenders will need documents to verify your income, financial holdings and other types of debt. Be prepared to submit documents like pay stubs, W-2s, bank statements, tax documents and mortgage statements.
5. Submit a formal application. This is also the time to submit more paperwork if your lender requires it.
6. Receive your money. Some secured loans, like mortgages, often take weeks before they close and you receive your funds. Other types of secured loans can get you cash much sooner. For example, if your loan is secured with a savings account or a CD, you may receive your funds within one business day.

What happens if you don’t repay your collateral loan?

Depending on the lender, your collateral loan might be considered to be in default just 30 days after you miss a payment. However, most lenders allow for a grace period after a borrower has  missed a payment. Your loan might be considered delinquent at that time, but most likely you’ll be able to work with your lender to come up with an acceptable payment plan before your loan actually goes into default.

If your account continues to be delinquent, you might be in danger of losing your asset, depending on the lender, the type of loan and the state where you live. Read the fine print in your contract to understand your loan’s payment obligations and check your state’s laws.

For example, depending on the lender, repossession of a car might occur within 90 to 120 days after a borrower’s last payment, and a lender may not necessarily have to go to court. If you’ve defaulted on your mortgage, the foreclosure process will usually begin once you are 120 days late, although in some states lenders may have to take you to court first.