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Collateral is any asset you use to secure a loan, such as a home, car or a bank account. If you fail to repay, the lender can seize the collateral to help recoup its losses. Follow along to learn what qualifies as collateral, how it works and whether getting a collateral loan might make sense for you.
What Is Collateral?
Collateral is a valuable asset you pledge as security for a loan. It can be a physical asset, like a car, or a financial one, such as cash in a bank account. If you fail to repay the loan as agreed, the lender can seize your collateral to help cover its loss.
Collateral is often the very item being secured with the loan. For instance, mortgage loans are typically collateralized by the homes they finance. A business may put up equipment or property as loan collateral. No matter the asset, a lender may seize and sell it after a loan default.
Cash can also be used as collateral, such as with secured credit cards. Your upfront deposit serves as collateral and usually sets your credit limit, so a $500 deposit doubles as a $500 credit line.
How Does Collateral Work?
Securing a loan with collateral shows the lender you have a personal stake in the loan and good reason to repay it as agreed. That reduces the lender's risk because it can seize your asset and sell it if you default on the loan. As a result, secured loans are often easier to qualify for and may come with lower interest rates or higher loan limits.
The collateral also needs to have sufficient value relative to the loan amount. If you stop making payments, the lender wants to be able to recover at least some of its losses by selling the asset. For example, a lender likely wouldn't accept an asset worth $1,000 as collateral for a $50,000 loan.
Understanding the Risks of Collateral
Think carefully before offering up collateral and consider what that might mean if you fall behind or default on your loan and the lender has to seize it. For instance, missed auto loan payments could lead to repossession of your car, which a lender may be able to do without advance warning or court proceedings. Along the same lines, missed mortgage payments could lead to foreclosure, with the lender taking possession of your house.
Before signing a loan agreement, make sure you understand how many missed payments lead to loan default and when the lender can take your collateral. It's also important to think about whether the payments fit your budget both now and in the future. If you can't keep up with the payments, the financial consequences can be serious.
Do All Loans Require Collateral?
Not all loans require collateral. Home and auto loans are usually backed by collateral, but many personal loans, lines of credit and student loans aren't. While secured loans carry a certain level of risk if payments aren't made, they may offer better rates and terms than unsecured loans if your credit is below average.
Types of Collateral Loans
Collateral loans, or secured loans, are quite common and come in many forms, including:
Mortgage Loans
Whether you get a conventional or government-backed mortgage, the home itself generally serves as the collateral. Be aware, if you fall behind on payments and default on your loan, the lender may foreclose on your home to recover its losses.
Home Equity Loans and HELOCs
Home equity loans and home equity lines of credit (HELOCs) are second mortgages that let you borrow against your home's equity to pay for a home renovation, a large unexpected bill or another expense. Most lenders require you to keep at least 15% to 20% equity in your home. While a home equity loan provides you with a lump sum upfront, a HELOC works more like a credit card with a revolving line of credit you can draw on as needed for a certain time period, often 10 years. In either case, you could lose your home if you miss too many loan payments.
Auto Loans
When you finance a vehicle, the car usually backs the loan. That's true whether you finance through a bank, credit union or dealership. If the loan goes unpaid, the lender can take back the vehicle through repossession.
Secured Personal Loans
Personal loans can be used for many purposes, including home improvements and debt consolidation. Most are unsecured, meaning they don't need collateral. But some lenders offer secured personal loans that may allow borrowers with subpar credit to use a vehicle, savings account or home as collateral. Just remember, the lender could take the asset if you're unable to repay the loan.
Secured Credit Cards
A secured credit card can be a useful tool for building credit if you have low credit scores or limited credit history. To open the account, you'll usually need to make a security deposit equal to your credit limit. The deposit serves as collateral, and you could lose it if you stop making payments.
What Can I Use as Collateral for a Loan?
Lenders accept many different types of collateral to secure your loan, including:
- Real estate: Generally, any home, property or other form of real estate you own can serve as collateral.
- Vehicles: When you finance a car, the vehicle you're purchasing typically serves as collateral for the auto loan. Some lenders also offer car title loans and other secured personal loans that allow you to use a vehicle as collateral. You may need to own the vehicle outright to qualify, and the lender may max your loan limit at 50% of the vehicle's value.
- Investments: Investment accounts are commonly used to guarantee securities-based loans, which were once mostly limited to high-net-worth borrowers but are now available to investors with smaller portfolios. Lender requirements vary, but you may be able to borrow between 50% and 95% of your portfolio's value through a loan or line of credit. However, most lenders won't accept assets held in a 401(k) or IRA as collateral.
- Cash: You can often offer up cash in a savings or certificate of deposit (CD) account as collateral on a personal loan. You may be eligible for a loan from the same bank that holds your savings, CD or another deposit account. Because the cash reduces the lender's risk, borrowers may be able to borrow up to the amount in the account. Paying the loan as agreed can also help build a positive credit history.
- Personal property and valuables: Many types of personal property can be used as collateral, including jewelry, fine arts, collectibles and precious metals. Before proceeding, understand the value of your assets and the potential risks. For example, let's say you secure a loan with your collection of fine art, and the loan goes into default. The lender can sell your art to recover losses. If the sale doesn't cover the full amount owed, then you may still be responsible for the remaining balance.
Learn more: What Can Be Used as Collateral for a Personal Loan?
Pros and Cons of Collateral Loans
A collateral-backed loan may offer benefits such as lower interest rates and easier approval, but it's important to understand the risks before applying.
Pros of Collateral Loans
Can make credit approval easier: Secured loans can be a good option for if your credit history is limited or your credit scores are low. Since collateral reduces the lender's risk, you may have a better chance of getting approved.
Access to more borrowing options: Using collateral may give you access to loan products that aren't available with an unsecured loan, especially if your credit is less than ideal.
May receive lower rates and better terms: Lenders often extend more favorable rates and fees on secured loans than on unsecured ones since these loans carry less risk.
Could qualify for larger loan amounts: Even if your credit is strong, you might consider securing a loan with collateral if you need a higher loan amount. The collateral may give the lender more confidence it can recoup its funds if you default on the loan.
Cons of Collateral Loans
Risks your collateral: If the loan goes into default, the lender may seize your collateral, which could mean losing your home, vehicle or other important asset. That's why it's important to borrow only what you need and be confident you can afford the payments.
Approval timeline could be longer: Some forms of collateral require extra time to review before a loan can be approved. For example, if you're securing the loan with jewelry, fine art or collectibles, the lender may need to have those items appraised. That could delay the processing and funding of your loan.
Could harm your credit: Foreclosures, repossessions and other derogatory marks can remain on your credit report for up to seven years. These negative credit marks can make it difficult to qualify for credit and loans in the future without paying higher interest rates.
Often includes limits on the asset: The lender may restrict the sale or transfer of the collateral and require insurance coverage until the loan balance is paid in full. That may limit your ability to manage the asset as you choose.
Is a Collateral Loan a Good Idea?
Whether you should take out a collateral loan can depend on your credit, your income stability and how much you can afford to risk.
When a Collateral Loan Could Make Sense
- You have poor credit. A secured credit card can help you build a positive payment history. Making on-time payments may improve your credit over time and help you qualify for loans and credit cards that may have been out of reach before.
- You need a lower interest rate. A secured loan may score you a lower interest rate and monthly payment because the collateral reduces the lender's risk.
- You have assets to borrow against. If you have valuable assets like jewelry, fine art or money in a savings account, you may be able to back a loan without disrupting your daily life. You can keep the asset as long as you make the payments as agreed.
- You're consolidating high-interest debt. You may qualify for a lower-rate secured loan that allows you to combine several high-interest balances into one loan. Run the numbers beforehand to make sure your borrowing costs will be lower, and the new loan will help you pay down the debt faster.
When a Collateral Loan May Not Be a Good Idea
- You're on unstable financial footing. A secured loan may not make sense if your income is unpredictable or your job feels uncertain, since falling behind could put your pledged asset at risk.
- Unsecured options are available. If you can qualify for good terms on an unsecured loan or credit card, you may not want to risk losing an asset by pledging it as collateral.
- You can't afford to lose the asset. Collateralizing a loan may not be worth it if the collateral is something you rely on, such as your home or vehicle.
- You need the money quickly. If the lender has to appraise the collateral or confirm ownership, it could delay the approval process and take longer than your desired timeline.
Learn more: Should I Get a Secured Loan to Build My Credit?
How to Get a Loan Without Collateral
While mortgages, auto loans and other loans require collateral, it is possible to take out unsecured loans, such as a student loan or personal loan, without collateral. Here's how:
- Check your credit. Get your credit report and score to see where you stand before you apply. On-time payments and lower balances impact your credit the most, since payment history and credit usage make up 35% and 30% of your FICO® Score☉ Θ, respectively.
- Shop around and prequalify. Rates and terms can vary widely from one lender to another, so it's wise to compare offers from several lenders. Prequalify first when possible so you can review likely offers without a hard credit inquiry affecting your score.
- Consider a cosigner. A creditworthy cosigner can help you qualify for an unsecured loan or secure a better rate than you might get on your own.
- Hold off on new credit before you apply. A new account or hard inquiry can temporarily lower your score and raise concerns you're taking on too much debt. Use that time to improve your credit, which could help you qualify for an unsecured loan with better terms later.
Check Your Credit and Track Your Progress
If your credit is less than ideal, you may only qualify for loans requiring collateral. Before applying for a new loan, consider checking your credit report and FICO® Score for free to see where your credit stands. Then, address any potential issues you find in your credit report and follow tips to improve your credit.