When you apply for a loan, the lender needs some form of assurance that you’ll repay the money you borrow. With an unsecured loan, that assurance comes from your credit score and credit history. Secured loans require collateral. Understanding what that means and how it can affect the borrowing process can help you make smarter borrowing decisions.
Collateral is something of value that a borrower pledges to a lender to help guarantee repayment of a loan.
Common examples are using your home to secure a mortgage or your car to secure an auto loan. Jewelry and expensive artwork could also be used as collateral. If the borrower fails to repay the debt, the lender can seize those assets to cover its losses.
Secured vs. Unsecured Loans: Why Collateral Matters
You may hear secured loans referred to as collateral loans. The two terms are interchangeable. The collateral varies by loan type. We’ve already mentioned home and auto loans. Did you know there are also secured personal loans? Banking institutions often promote these as “credit-builder loans” because they’re offered to borrowers with less-than-perfect credit.
Unsecured loans are a different animal. Loan approval is based on information including credit score, repayment history, and other factors. Since there’s no asset backing the loan, lenders take on more risk, which usually translates to higher interest rates and stricter credit requirements. Examples of unsecured loans include personal loans, student loans, and credit cards.
Lenders are more likely to require collateral when a borrower has a limited credit history, a lower credit score, or is requesting a larger loan amount. If you’re unsure what documents you need to apply for a loan, ask your lender. You could also check their website for an FAQ section, but personal contact is better if you have additional questions.
Common Types of Collateral
Many assets of significant value may be used as collateral, subject to lender guidelines and applicable federal and state regulations that limit what can be accepted. Vehicles are commonly used to secure auto loans and other types of secured financing. Vehicle value is typically determined using NADA guidelines, which consider multiple factors beyond age and condition when evaluating a car, truck, or SUV.
Some lenders only accept financial assets as loan collateral. That could include savings accounts, certificates of deposit, brokerage accounts, and the cash value of life insurance policies. Traditional lenders, banks, and credit unions may not accept personal property like jewelry, art, and collectibles. Check with the lending officer before applying.
How Lenders Value Collateral
Getting approval for loans with collateral requires an extra step that is not part of the unsecured loan approval process. The secured lender needs to assess the collateral’s fair market value. For real estate, that means a formal appraisal. Vehicles have industry pricing guides. Specialty items may require an independent expert evaluation.
Another factor is the loan-to-value ratio (LTV), which is the percentage of the asset’s value that the lender is willing to lend. For example, an 80% LTV on a home valued at $200,000 means the lender would offer up to $160,000. A higher LTV generally means a higher interest rate, because the lender is taking on more risk relative to the collateral’s worth.
Lenders will also verify ownership, check for existing liens, and physically inspect any assets used for collateral. If there are title issues, you may not be able to use that asset for collateral. Lenders want to see clear ownership to mitigate their risk. Anything short of that will complicate the process and lower your chances of securing a loan.
Pros and Cons of Using Collateral
Collateral loans typically have lower interest rates, a clear benefit for the borrower. Lenders do this because collateral significantly reduces their risk. Depending on the asset’s value, you might also qualify for higher loan amounts. If you are working to rebuild credit with installment loans, secured loans can be a practical path to achieve your goal.
Keep in mind that your primary risk with a secured loan is losing your collateral. That can cause serious unmanageability if the collateral is your home or car. Lenders know that, and your interest rate and repayment terms reflect it. You may also be restricted from selling a collateral asset, so that won’t be an option if you fall behind on your payments.
What Happens If You Can’t Repay
You don’t just lose your collateral when you miss a payment or two. The lender will send you delinquency notices first, followed by a “Right to Cure” notice to give you a chance to catch up. If the debt remains unpaid, the lender can initiate repossession of vehicles or foreclosure proceedings for real estate, depending on the loan type and applicable state laws.
Defaulting on a secured loan can significantly damage your credit score and limit your ability to borrow in the future. You may also still owe money even after the lender takes and sells your collateral. If the sale doesn’t bring in enough to cover what you owe on the loan, the remaining unpaid amount is called a deficiency balance. That balance is still your responsibility, which means you could continue to receive collection notices and face further collection efforts.
How to Use Collateral Strategically
If you’re weighing your options, reviewing key questions to ask before taking out a personal loan can help you avoid potential pitfalls. The first of these is to make sure the loan you’re applying for is the right fit. Ask your lender about matching the collateral to the loan’s purpose and size. For example, you don’t want to put your house up to borrow $5,000.
For best results, shop multiple lenders to compare interest rates, LTV limits, and terms. You’ll also want to keep insurance and maintenance current on the pledged asset to avoid breaching your loan agreement. Before you sign anything, understand the prepayment options, refinancing possibilities, and the conditions under which the lender would release the collateral.
Alternatives to Pledging Collateral
A collateral requirement on a loan is often a solution to having a poor credit history, but it’s not your only choice. Asking a close friend or family member to cosign the application could be the key to approval for an unsecured loan, and it doesn’t require you to pledge an asset. You could also go to a credit union that has more flexible underwriting standards.
Asking for less money and agreeing to shorter payment terms on an unsecured loan are other alternatives to applying for a collateral loan. You can use these options to build your credit and apply for a larger loan later. Visit the 1st Franklin Financial FAQs page for more information on available loan options. We’re happy to answer any questions you might have.
Common Loan Collateral Questions
