Whether you’re a small business owner looking for a small business loan or looking to make a sizable personal purchase, you may be considering taking out a loan. Loans provide a way for people to pay for things that they can’t afford upfront, which sounds great in theory, but should not be taken lightly. Taking out a loan is a huge financial decision, as it can hurt you as much as it can help you.
Above all, you should make sure that taking out a loan is absolutely necessary, and that you have a plan to pay it back. Even if such a plan exists, your lender may not be so sure. This is primarily why collateral loans exist. In this article, we are going to cover everything you need to know about collateral loans, how they work, and why (or why not) you should consider taking one.
Backed with the right information, you can make sure that your financial decisions are safe and sound.
What Is Collateral?
Before we dive into collateral loans, let’s go over what it means for something to be collateral.
Collateral is when a creditor offers the lender an asset, or a personal item or resource of economic value, as security for the loan. So, if the borrower defaults and cannot pay back the loan that they have received, the lender will seize the collateral and sell it, applying that money towards the amount due by the borrower.
Collateral helps lenders minimize the risk of giving out loans. This means that borrowers can often receive loans with a much lower interest rate. However, collateral loans present a significant risk for borrowers so you can expect those to be high interest rates in the grand scheme of things.
If the borrower is forced to pay the lender in collateral, they are legally obligated to give up whatever they pledged, which oftentimes is something as significant as a car or home.
What Can Be Used As Collateral?
Collateral takes different forms depending on the nature of the loan you are receiving. There are many common types of collateral. For instance, if need an auto loan for a new car, that car will serve as collateral. The case is similar to mortgages. When you take out a mortgage, your collateral is the home that you’ve purchased.
If you’re looking to take out a personal collateral loan, a personal asset‘s eligibility for being collateral will depend on its worth. Typically, the asset must have an appraisal worth twice the monetary value of the amount being borrowed. This is in order to protect lenders in case the collateral loses value over time.
Common forms of collateral for personal loans include:
- Cash In a savings account
- Fine Art
- Precious Metals
- Homes or real estate
Furthermore, banks also offer smaller short-term loans, which are usually paid off in a couple of weeks. Future paychecks are accepted as collateral for these types of loans, however, these types of loans are intended for genuine financial emergencies rather than casual spending.
Reasons For Collateral Loans
With such high stakes for the borrower such as potentially losing a home, taking out a collateral loan may seem unreasonable, or even irresponsible. However, deciding to use collateral loans is often a very practical and even necessary decision. For instance, many new businesses will be required to pledge collateral since they lack a track record of their business’s success.
Additionally, collateral loans have a higher chance of being approved. For those who lack an extensive credit history, pledging collateral will make up for the fact that your lender can’t confirm that you have a track record of making payments on time. Furthermore, pledging collateral often allows borrowers to borrow more money, as well as secure loans with lower interest rates.
Difference Between Collateral Loans and Unsecured Loans
If you’ve done any sort of preliminary research on taking out a loan, chances are you’ve also heard of something called an unsecured loan in addition to a collateral loan. Unlike a secured loan, unsecured loans are loans that aren’t attached to any sort of collateral, meaning that if you default, your lender can’t seize any of your personal property. Popular unsecured loans include:
- Credit cards
- Student Loans
- Car title loan
- Certain Personal Loans
Unsecured loans, however, come with their own set of risks. Failure to make your payments on time will result in a hit on your credit score. While you aren’t giving up an asset, a low credit score can negatively impact your ability to qualify for things like a credit card, apartment, and future loans just to name a few.
Types of Collateral Loans
While there are many different kinds of collateral loans, let’s go over some common ones that you are likely to encounter.
As mentioned above, mortgages are collateral loans and one of the most popular kinds at that. In fact, nearly half of all homeowners have a mortgage. With the median cost of a home in the US being just shy of 300,000, taking out a mortgage is often a necessary step for those looking to buy a home.
It’s important to note that if the borrower fails to make a payment towards their loan for over 120 days, the lender can begin the legal action required to “foreclose” the house, meaning that the property is transferred to the lender. The lender can then sell the house in order to pay off the remaining principal (or money agreed by a borrower to pay back) on the loan.
Home Equity Lines of Credit (or HELOC) also involve using your home as collateral. A HELOC is essentially a second mortgage that often comes with extremely competitive rates, using the equity you have in your home as well as your first mortgage as collateral.
With HELOC’s the amount of your loan can be no more than the available equity. So, let’s say your home is valued at $300,000, and you still owe $200,000, your loan couldn’t exceed $100,000. Furthermore, the more collateral loans you take out, the more risk you create for yourself as a borrower as you will have a greater loss if you continually fail to make your loan payments.
In the case of margin trading, the balance in the investor’s brokerage account is used as collateral for the broker. Like other collateral loans, this can be risky if the investors’ stocks end up losing value.
Collateral Loans: Pros and Cons
Taking out a loan, or even taking out a line of credit can be a tricky business. Luckily, businesses such as Seek Capital can help you make smart choices that make the most sense for your individual financial situation. In the case of collateral loans, in particular, there are several pros and cons to consider, so let’s take a closer look at a few.
Pros of Collateral Loans
For those with a limited credit history or a not-so-great credit score, collateral loans are the way to go. While these factors may prevent you from qualifying for unsecured loans, the chances of securing a collateral loan are much greater since the collateral provides a safety net for the lender.
Not only does collateral make lenders more likely to approve you, but it also gives them the peace of mind to give out larger loan amounts. This larger amount, however, is dependent on the value of your assets.
While you may have lots of valuable assets such as a home, jewelry, or fine art, you, unfortunately, can’t use these to pay for things in the checkout line. Collateral loans allow you to transform these assets into short-term liquidity, without having to deal with the difficult process of selling those assets.
Although this was already mentioned above, it is worth repeating. Collateral loans come with lower interest rates than unsecured loans. Depending on the size of your loan, this can borrow hundreds of dollars in the long run.
Cons of Collateral Loans
Complicated Application Process
The process of applying for a collateral loan is more complicated than applying for an unsecured loan. This is because lenders have to value your assets and receive more information from you in order to properly do so. The amount of time this valuation takes varies from vendor to vendor.
Potential To Lose Assets
Of course, the biggest downside of using a collateral loan is the possibility of losing your pledged assets. Using a highly valuable asset such as your home as collateral is particularly risky, possibly resulting in life-changing consequences. Needless to say, it’s imperative to make your loan payments on time.
Requires a Valuable Asset
While collateral loans may not require outstanding credit, they do require that you have a valuable asset to use as collateral. This asset’s value must be at least equal to and oftentimes much greater than the number of money borrowers in the loan.
The Bottom Line
Collateral loans are extremely common, and odds are you’ll use one yourself if you intend to purchase a home or vehicle. When it comes to collateral, the easier it is for the lender to value the more likely they are to accept it. So for example, you’ll likely have more success pledging a large sum in your savings account as collateral as opposed to your great grandfather’s handcrafted clock collection.
Just like any other loan, keeping track of your finances and being responsible for your payments is extremely important. As long as you have a solid plan for repayment, taking out a collateral loan can bring you one step closer to achieving your personal and business dreams.