A collateral loan is one that is secured by personal property, cash, investments or real estate that has value sufficient to cover the outstanding debt. Not all loans are secured, but there are some loans that typically require the borrower to pledge collateral. Collateral will likely be required if you’re considering one of these financing options:
Mortgages are one of the most well-known types of secured loans. When financing a home or other real estate, the buyer pledges that real estate as collateral so that the bank’s risk is limited in the case of default and subsequent foreclosure. While the owner holds the deed to the real estate, their title is encumbered by a mortgage that gives the lender the ability to foreclose on—and seize—the property if the borrower fails to make payments.
As with mortgages, most auto loans are collateralized by the vehicle being financed. In the case of a car loan, however, the lender holds title to the vehicle until the loan is paid in full. If a borrower defaults on the loan, the bank can repossess the car.
Secured Personal Loans
In contrast to unsecured personal loans, secured personal loans require the borrower to pledge collateral to limit the lender’s risk. Though not all lenders offer this option, secured personal loans can make it easier for low-credit applicants to get approved. These secured loans can also help borrowers access lower interest rates or, perhaps, qualify for higher loan amounts.
Secured Credit Cards
If you have a low credit score—or haven’t developed credit history at all—it may be difficult to qualify for a credit card. This can make it even more difficult to build a credit history. To address this issue, some banks and credit card companies offer secured credit cards. With this type of card, the bank extends credit equal to (or close to) the cash a cardholder places in an in-house account and pledges as collateral.
Pros of Collateral Loans
Collateral has a number of benefits that make it a helpful tool when applying for loans, credit cards and lines of credit. These advantages may make a secured loan a good financing option:
- Collateral can help borrowers access credit or loans in spite of having a low credit score or limited credit history.
- Likewise, collateral loans can help borrowers build their credit by demonstrating on-time payments.
- Secured loans and credit cards may come with lower interest rates than their unsecured counterparts.
- Borrowers that provide collateral may be able to access larger loan amounts or higher credit limits than available with unsecured financing.
Cons of Collateral Loans
Still, the mechanics of collateralized loans mean that a secured loan may not be your best option. Here are some things to consider before pledging collateral:
- Using something as collateral puts the property at risk if the borrower defaults on the debt.
- Secured loans involve a more extensive application process that may include an appraisal.
- Oftentimes, the loan must be used to purchase the item serving as collateral.
Can You Get a Loan Without Collateral?
Collateral is a necessary element of many financing options—like mortgages, home equity loans and auto loans—but it is possible to get a loan without collateral. Unsecured personal loans, for example, provide borrowers an opportunity to access cash without having to pledge something like cash or investments as collateral. Likewise, most credit cards are unsecured, meaning that you can access a revolving line of credit without providing collateral.