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Whether you're just beginning to build credit or your credit is a work in progress, it may be easier to qualify for a loan if you're willing to put up some kind of collateral. This may be your home, car or the first edition copy of "Alice's Adventures in Wonderland" you keep in your safe.
Loans secured with collateral may also help you qualify for a lower interest rate and better terms. Then again, it could mean risking your collateral if you fail to repay your debt. Consider these pros and cons of collateral loans before you apply.
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.
There are several common types of secured loans:
- Mortgages: When you take out a mortgage, your home serves as collateral for the home loan. If you miss enough payments and default on your loan, the lender may take possession of your home in a process called foreclosure to recoup their losses.
- Auto loans: If you get a loan to buy a car, truck, motorcycle or another vehicle, the vehicle it is used to purchase typically secures the loan. If you fail to pay back the auto loan, the vehicle could be repossessed.
- Secured personal loans: A secured personal loan guaranteed with collateral may be easier to qualify for and you may be eligible for better rates and terms on your loan. However, you risk losing the asset you used to secure the personal loan if you default.
Although each of these loans can be an effective way to borrow money and fill a need, there are both benefits and risks to be aware of.
Pros of Collateral Loans
Most banks, credit unions and other financial institutions offer collateral loans. Although rates and terms vary from one lender to the next, the pros are similar no matter where you get your loan.
Good if Your Credit Needs Work
If you're establishing credit for the first time, have a short credit history or your credit needs work, a collateral loan could be a good option to get the funds you need. Lenders check your credit score, credit history, income and other factors when evaluating your creditworthiness and risk of defaulting on your loan. So, even if your credit needs work, you may still be able to qualify for a loan if you're willing to put up collateral. That's because collateral reduces the risk to the lender, which may make them more likely to approve your application. If you miss payments or can't pay back your loan, they can use your collateral to recoup their loss.
Potential for Better Rates and Terms
Because you are reducing the lender's risk by securing your loan with collateral, it's possible you may be eligible for better interest rates and terms on your loan. With a large loan, even a slight reduction to your interest rate could save you significantly over the life of the loan.
Possibility of Larger Amounts
Although available loan rates, terms and loan amounts vary from one lender to the next, it's possible you may qualify for a larger loan amount with sufficient collateral. In addition to determining the rate you receive based on the asset you offer as collateral, the lender may also determine the loan amount based on your asset's value.
Cons of Collateral Loans
Besides the benefits collateral loans can offer, there are also drawbacks.
Risk of Losing Your Collateral
The single greatest drawback of collateral loans is the risk of losing your collateral if you cannot pay back your loan. If you have a mortgage or auto loan you cannot repay, losing those assets to the lender could cause you serious hardship.
Longer Qualification Time
Because it can sometimes be difficult to put a value on your collateral, the approval process for a secured loan may take longer than with an unsecured loan. For instance, let's say you have a valuable art collection you are using as collateral for your loan. Finding a qualified professional to evaluate the worth of your collection can take time and may delay you receiving the proceeds from the loan.
Potential to Harm your Credit
Defaulting on a secured loan has the same credit consequences as defaulting on any other type of credit. If you default on your loan and your lender repossesses your collateral assets, that blemish can remain on your credit report for up to seven years.
When you consider that the most important factor when calculating your credit score is payment history—accounting for 35% of your FICO® Score☉ —the impact of failing to repay your loan could be significant.
Is a Collateral Loan a Good Idea?
Collateral loans can be beneficial under certain circumstances. 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 consider that a collateral loan presents a substantial risk if you have to forfeit your collateral because you cannot make payments.
If you have the income and a plan for paying back the loan, which may take in any unforeseen circumstances, then a collateral loan is probably a safe bet. But if you're already strapped for cash, you don't feel comfortable putting up your house as collateral or you don't have collateral that qualifies for a secured loan, then you may want to consider an alternative funding option.
Alternatives to Collateral Loans
If you've researched your options for collateral loans and decided they may not be for you at this time, it's good to know there are alternatives.
Unsecured Personal Loan
Unsecured personal loans that you can typically get through banks, credit unions, online lenders and peer-to-peer lending platforms do not require any type of collateral. Instead of relying on an asset as security for the loan, lenders approve unsecured loans based on your overall creditworthiness. 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. Plus, it's not uncommon that you may still pay a higher interest rate than a secured loan even with good credit.
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Unsecured Credit Card
Credit cards can be secured for borrowers whose credit needs work, or unsecured. Used wisely, they can be another alternative to a collateral loan, but they may carry higher APRs. Some credit cards come with an intro 0% APR, which could help you save on interest. During the temporary promotional period, you pay no interest on purchases; after the intro period ends, you'll pay interest on any remaining balance. 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 even if your credit is less than perfect, and might also help you get a better interest rate and terms. A cosigner can be a family member or trusted friend who takes responsibility for repaying any missed payments or even the full amount of the loan if you are unable. Having a creditworthy cosigner gives your lender the confidence the loan will be repaid, but not all lenders allow cosigners. Adding a cosigner and making on-time payments each month on your loan can help boost your credit and make you a better candidate for credit without one in the future.
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.
The Bottom Line
Sometimes, it can be easier to get a loan if you're willing to put up some kind of collateral, like your vehicle, home or other valuables you own. Collateral loans use valuable property to secure the money you're borrowing, and generally provide lower interest rates. They may be a good option for someone working to improve their credit.
Like with other loans, a collateral loan requires having a plan to pay the money back, even if you experience an unexpected financial emergency. With a secured loan, failing to repay your debt can mean losing your asset. With this in mind, before you apply for a collateral loan (or any other type of credit), review your credit report and scores to see where you stand.