Collateral is an asset or something you own that you offer to a lender as compensation in the event that you default on your loan payments. If this happens, the lender has the legal right to seize whatever was offered as collateral and resell it to make up for the money they lost.
Loans that require collateral are considered secured loans, because the lender is protected against losing money in the form of the collateralized item. Loans that don’t require this are called unsecured loans.
Why do some loans require collateral?
Most financial institutions use secured loans, including national banks, community banks, credit unions and online lenders.1 When lenders are deciding whether or not to offer you a loan, they look for factors that determine if you’re creditworthy, like your credit score, monthly income, debt-to-income ratio and payment history. If the lender believes that you may have trouble paying back an unsecured loan, they may ask you to offer something as collateral to reduce their risk.
On the other hand, some types of loans such as a home mortgage will always require collateral, regardless of the applicant’s credit history and income.
A secured loan may have a lower interest rate than an unsecured loan, since it is less risky for the lender. The type of collateral you can offer will depend on the type of loan you’re applying for. Let’s take a look at how this works with personal loans.
Common examples of collateral
There are many different types of collateral that can be used to secure personal loans, including:
- Motor vehicles — If your car is paid off and meets the lender’s requirements, you can use it as backing for your loan.
- Savings — A savings account can sometimes be used as collateral for personal loans. In the event of default, the lender can take the funds as compensation. In this sort of arrangement, the savings will often need to be secured in a CD (certificate of deposit) account. The borrower will not have access to the funds until the loan is paid off.
- Paychecks — This is when a loan is secured using the borrower’s actual income. In the event that the borrower defaults on the loan, they will be subject to wage garnishments.
- Personal goods — Some lenders allow valuable property to be used to back a loan, including jewelry, fine art or collector’s items.
It is important to note that some lenders like OneMain Financial only accept certain items as collateral, so you should always check with your lender first before applying for a loan.
What are the benefits of using collateral?
Offering collateral to get a secured personal loan can be a good option for a lot of people. This is especially relevant if you have a fair or poor credit score because using collateral can improve your odds of getting a loan and could qualify you for a larger loan amount.
Another advantage of collateral is that you may pay less overall in interest. This is because a secured loan is by nature less risky for the lender than an unsecured one, so they may be more willing to give you a lower interest rate.
Of course, you must always keep in mind: If you do not pay back the loan, you will lose the item offered as collateral. If you are diligent about making payments on time, using your assets or property to secure a loan can be a responsible option.
Is using collateral right for you?
Everyone’s financial situation and needs are unique. If you have items of value or cash in the bank, offering them as collateral can be a useful way to get access to the liquidity you need. Always make sure that you are comfortable with this and be certain that you can make the monthly payments according to the terms of your new loan.
1. Bond, Casey. “Everything You Need to Know About Collateral Loans.” Loans.USNews.com. https://loans.usnews.com/everything-you-need-to-know-about-collateral-loans (accessed March 19, 2020.)
This article was originally published on May 1, 2019. Joe Guida contributed to this article.