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Generally speaking, it’s significantly easier to get a secured loan versus an unsecured loan. When you put collateral behind a loan, it means you’re securing the loan. This decreases the lender’s risk and therefore improves your chances of being approved for the loan.
What is collateral?
Collateral is a valuable item that’s put up against a loan. You’re essentially promising the lender that they get to take that collateral if you stop making payments, and if that happens, the lender will then sell the collateral to recoup their losses.
Types of collateral
Collateral can be anything that has a value attached to it. Some of the most common types of collateral are:
- Real estate, including your home, equity in your home or investment properties
- Vehicles, including motor homes
- Cash accounts (however, retirement accounts are usually an exception and won’t count for collateral)
- Machinery and equipment from your business or personal use
- Investments, stocks and bonds
- Insurance policies
- Valuables and collectibles (Rolex watches, jewelry, family heirlooms, coin collections, valuable art pieces, etc.)
- Accounts receivable and invoices
- Future paychecks
- A blanket lien
Note that some forms of collateral are harder to approve than others. For example, Jeff Allen, director of operations for the small business consulting firm Tredant, emphasizes that while accounts receivable are considered collateral, they pose a challenge for loan approvals. Allen states that using accounts receivable “might be more difficult because [they’re] harder to authenticate.”
How does a collateral loan work?
When you sign a secured loan, you’re giving the lender rights to the specified collateral if you ever stop making payments. Under your loan terms, the lender can take the collateral and resell it. With an unsecured loan, though there are still negative consequences if you don’t make your payments, you aren’t putting any property on the line.
Lenders don’t want to approve risky loans. The cost of legal fees in pursuing unpaid debts can often make the whole process not worth it. As a result, lenders would prefer to take the collateral as assurance.
The borrower can benefit from a secured loan too. When you provide collateral, you typically get better interest rates and higher loan amounts.
Secured loans are a lot more common than you may realize. Some popular types of collateral loans are mortgages, auto loans, secured personal loans and home equity lines of credit. When it comes to an auto loan or a mortgage, the item you’re purchasing is the collateral itself. If you stop making payments, the lender takes back the vehicle or the house.
When you apply for a collateral loan, the lender assesses your item’s market value. You’re then approved for a loan that’s a percentage of what your asset is worth. Of course, as the collateral’s entire point is to reduce the lender’s risk, they won’t give you a loan for the full value of the item.
Banks use a loan-to-value (LTV) ratio when determining how much of a loan can be approved for a piece of collateral. Typically, the lender will only approve 70 to 80 percent of the collateral’s value. So if you have a vehicle that’s worth $10,000, your lender may approve a loan for only $7,000 to $8,000.
Benefits of collateral loans
There are several benefits to collateral loans that make them a solid option. First, since your loan is secured, you’ll usually get a lower interest rate. Additionally, there are often less strict requirements to qualify. This is ideal for individuals with low credit scores or poor credit history who find themselves denied unsecured loans.
Additionally, if you’re someone who has thin or bad credit, a collateral loan can help you build up your credit. Of course, you have to make full, on-time payments to positively impact your credit.
Drawbacks of collateral loans
As is the case with most loans, there are some drawbacks to a collateral loan. First, you’re holding a lot of risk with this loan, and you could lose your asset entirely.
Secondly, while the application process may be more lenient, it’s also more complicated. This is because the lender has to take the time to assess your collateral’s worth.
Lastly, as with any credit, if you don’t make your payments, your credit will be negatively impacted.
How to apply for a collateral loan
You can apply for a collateral loan at a bank, a credit union, an online lender, an auto dealership and even some pawn shops.
Check your credit
The first step is to check your credit score. The better your credit score, the lower your interest rate will be. If your credit score seems shockingly low, get a copy of your credit report to ensure there are no mistakes on it.
Do your research before you apply
You have many options when it comes to a collateral loan. However, you should do your research first. Banks, online lenders, auto dealerships and credit unions all typically offer collateral loans. While you technically can go to a pawn shop for a collateral loan, it’s not recommended. This type of collateral loan can come with highly unfavorable terms.
Look at several lenders to compare your options. Ideally, try to see your options without the lender pulling a hard credit check. A hard inquiry will typically make your credit score go down a few points, while multiple hard inquiries in a row can really damage your score.
Some lenders will pull a soft credit check—which doesn’t impact your score—to prequalify individuals. Once you’ve prequalified with a few lenders, choose the best rate and the lender you select will pull a single hard credit check.
When you need a loan, it can be tempting to go with the first offer. However, it’s in your best interest to do some shopping around. Go to a few lenders to see what interest rates, loan amounts and loan terms you can get. We recommend comparing at least three lenders’ offers.
Compile relevant documents
When you’re ready to proceed with a lender, they’ll have to verify your income, taxes and debt. Expect to have to provide relevant documents such as tax documents, pay stubs, mortgage documents and more.
Complete your application
At this stage, your lender will require that you finish the process by submitting your formal application. Once the application is finalized, you’ll receive your loan.
Make the best choice for your finances
A collateral loan isn’t for everything. If you’re putting up collateral like your home, your only vehicle or essential assets from your business, the risk can be too significant. If this is the case, consider alternative loan options. You can try to get a loan with a cosigner, get an unsecured loan, get a loan online or get a secured credit card. It’s very likely a collateral loan isn’t your only option, so make sure you consider what’s best for your situation.
Ultimately, if you want access to more loan options, you should consider focusing on your credit. Your credit score and credit history can give you access to many opportunities when your score is high. Conversely, a low credit score limits you from certain financial options. You can work on fixing your credit score by learning more about credit and working with a credit repair service.
Reviewed by Kenton Arbon, an Associate Attorney at Lexington Law Firm. Written by Lexington Law.
Kenton Arbon is an Associate Attorney in the Arizona office. Mr. Arbon was born in Bakersfield, California, and grew up in the Northwest. He earned his B.A. in Business Administration, Human Resources Management, while working as an Oregon State Trooper. His interest in the law lead him to relocate to Arizona, attend law school, and graduate from Arizona State College of Law in 2017. Since graduating from law school, Mr. Arbon has worked in multiple compliance domains including anti-money laundering, Medicare Part D, contracts, and debt negotiation. Mr. Arbon is licensed to practice law in Arizona. He is located in the Phoenix office.
Note: Articles have only been reviewed by the indicated attorney, not written by them. The information provided on this website does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client or fiduciary relationship between the reader, user, or browser and website owner, authors, reviewers, contributors, contributing firms, or their respective agents or employers.