Edited by Samuel MountjoyAre Collateral Loans a Good Idea?
Edited by Samuel Mountjoy
Quick Answer
If you need a loan but your credit needs work, a collateral loan may be an option. But you could risk losing the asset you put up for collateral if you can’t afford your loan payments.
A collateral loan is a type of loan that requires borrowers to put up some kind of collateral. Certain types of loans typically require collateral for even well-qualified borrowers, while with others it may be an optional way to more easily qualify for a loan or receive better terms.
Collateral loans come with the risk of losing your collateral if you fail to repay your debt. Before applying for a collateral loan, it's important to weigh the pros and cons carefully.
What Is a Collateral Loan?
Loans can be secured or unsecured. A collateral loan, or secured loan, is guaranteed by an asset you own. If you stop repaying your loan, the lender has the right to claim the collateral.
Common types of secured loans include:
- Mortgages: Your home serves as collateral when you take out a mortgage. The lender can take possession of your home in a process called foreclosure if you fall behind on your mortgage payments or default on the loan.
- Auto loans: When you finance a car, truck, motorcycle or another vehicle, your vehicle is used to secure the loan. Your lender can repossess the vehicle if you fail to pay back the auto loan to recoup any losses.
- Secured personal loans: Secured personal loans are secured by an asset of value, such as a savings account, car or stock assets. They may be easier to qualify for, have lower interest rates and higher loan amounts than unsecured personal loans.
Pros of Collateral Loans
Collateral loans offer several key advantages for borrowers. Consider these common benefits of taking out a secured loan:
Good if Your Credit Needs Work
Lenders typically check your credit history when you apply for financing to help determine your ability to repay the loan. If you're establishing credit for the first time, have a short credit history or your credit needs work, a collateral loan could make it easier to get approved. A collateral loan can also help you build credit by adding to your credit mix and creating a positive payment history.
Potential for Better Rates and Terms
Many collateral loans come with better interest rates than unsecured loans because the collateral you put down reduces the lender's risk. With a large loan, even a slight reduction to your interest rate could save you significantly over the life of the loan.
Learn more: How to Get a Loan With Bad Credit
Possibility of Larger Amounts
Available loan rates, terms and loan amounts still vary depending on the lender, but you may be able to qualify for a larger loan amount with a collateral loan than you could with an unsecured loan. Lenders typically consider the type of asset used for collateral, along with the asset's value, when determining loan amounts for secured loans.
Cons of Collateral Loans
It's important to be aware of the disadvantages of collateral loans. Consider these common downsides of using a secured loan:
Risk of Losing Your Collateral
The greatest drawback of collateral loans is the risk of losing your collateral if you can't pay back your loan. For example, if you default on your mortgage or an auto loan, the lender can take your home or vehicle. Losing major assets you rely on could easily cause you serious financial hardship.
Longer Qualification Time
The approval process for a secured loan often takes longer than an unsecured loan since the lender needs time to put value on your collateral. Turnaround times vary widely, depending on the lender and type of asset that needs to be valued. It usually takes longer for you to receive funds in your account after secured loan approval as well.
Potential to Harm Your Credit
Defaulting on a secured loan can affect your credit in the same way defaulting on any other type of credit would. If you default on your loan and the lender repossesses your collateral assets, that blemish can remain on your credit report for up to seven years. And when you consider that the most important factor when calculating your credit score is payment history—accounting for 35% of your FICO® ScoreΘ—the impact of failing to repay your loan could be significant.
Is a Collateral Loan a Good Idea?
A collateral loan could be a good idea in certain situations. For instance, if you have less-than-perfect credit and can't qualify for a loan any other way, a secured loan may be a good choice. At the same time, it's important to carefully consider the risk of losing your collateral should your financial situation change and affect your ability to make loan payments.
When a Collateral Loan Could Be a Good Idea
Here are a few circumstances when a collateral loan might make sense:
- You're consolidating high-interest debt. Using a secured loan to pay off high-interest balances could help you save money compared to an unsecured loan since interest rates are often lower. Just be sure to avoid racking up additional debt while paying off the loan.
- You're having trouble qualifying for an unsecured loan. A low credit score could prevent you from qualifying for an unsecured personal loan. Offering collateral for a secured loan may improve your approval odds and potentially help you qualify for better terms or a higher loan amount.
- You need to borrow a larger amount. Secured loans sometimes allow higher loan limits because the lender has an asset backing the loan. However, the amount you might qualify for often depends on the type of collateral and its value.
When a Collateral Loan May Not Be a Good Idea
Here are a few circumstances when a collateral loan might not make sense:
- You don't want to risk losing the collateral. Losing an important asset, like your car or savings, could create bigger financial problems if you default on the loan.
- You lack stable income. If your ability to repay the loan isn't predictable, putting an important asset on the line may add financial stress and could put your credit at risk.
- You qualify for a low-rate unsecured loan. If you can get competitive terms and the loan amount you need without putting up collateral, an unsecured loan usually carries less risk.
Alternatives to Collateral Loans
If a collateral loan feels too risky or you don't qualify, here's some alternatives to consider.
Unsecured Personal Loan
An unsecured personal loan is an installment loan that can be used for different purposes and doesn't require collateral. You won't risk losing your collateral if you default on your loan, but you'll likely need good to excellent credit to get approved. If you qualify, you may be able to get funds fast—often within a day.
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Unsecured Credit Card
Used wisely, unsecured credit cards may be a solid alternative to a collateral loan, but they may carry higher APRs. If your credit needs work, you may also be able to qualify for a secured credit card. Some credit cards come with an intro 0% APR, which could help you save since you won't have to pay interest until after the introductory period ends. Many credit cards also let you earn rewards, but might also charge annual fees and carry high interest rates.
Cosigned Loan
Adding a cosigner to your loan may help you to qualify if your credit is less than perfect. You may also get a better interest rate and terms. Having a creditworthy cosigner gives your lender the confidence the loan will be repaid. And making on-time payments each month can help boost your credit overall. A cosigner can be a family member or trusted friend who is legally responsible for repaying the loan if you can't make your payments. Not all lenders allow cosigners on loans, so you may have to shop around.
Credit Union Loan
Credit unions may be more flexible when providing loans than some traditional banks. This may be because they are not-for-profit organizations owned by their members, and can offer quick approvals and competitive rates that are often lower than some bank rates. Some credit unions may also offer payday alternative (PAL) loans, which are an affordable alternative to expensive payday loans. However, to get any type of loan through a credit union, you must first become a member.
Frequently Asked Questions
The Bottom Line
A collateral loan may make it easier to qualify for a loan if you're willing to put up some kind of collateral, like your vehicle, home or other valuables you own. Compared to unsecured loans, collateral loans generally provide lower interest rates and you may be able to borrow a higher loan amount. You may also be able to qualify for a collateral loan with less-than-perfect credit. But putting your assets on the line can be risky.
Before submitting any applications, knowing where your credit stands and watching your progress can be important. With Experian, you can check your FICO® Score for free. You can also use tools from Experian to see personalized loan offers.
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About the author
Sarah Archambault
Sarah Archambault is a personal finance writer and editor who enjoys helping others figure out how to make smart financial decisions. She’s an expert in credit education, auto finance, banking, personal loans, insurance and credit cards.
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