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Updated on Thursday, January 25, 2018
If you need a loan for any reason, whether you’re refinancing high-interest debt or paying for home improvements, you may be considering a personal loan. However, qualifying for an unsecured personal loan can be difficult if you don’t have a stellar financial history, credit score or debt-to-income ratio.
If that’s the case, you might be tempted to apply for a secured loan instead. We’ll tell you everything you need to about collateral loans here.
What is a collateral loan?
A secured loan, or collateral-backed loan, is one backed by your assets, which could include things like a vehicle, a savings account or a piece of property, or real estate.
A person with less-than-stellar credit might have a better chance of qualifying for a collateral loan because the lender knows they can seize that person’s assets if he or she defaults and misses payments on the loan.
Many people may not have heard the term collateral loan in everyday life, but that’s because they’re rarely called by that name specifically. Chances are you’re familiar with some of the most common collateral loans — a home loan (aka a mortgage) and car loans. These types of loans are generally secured by the asset being purchased with the loan.
It’s also not uncommon for people to take out a collateralized personal loan using an asset they’ve already owned for some time. For example, you’ve probably heard of a title loan, which is a type of loan that requires the title of a paid-off vehicle as collateral to back it.
How a collateral loan works
Collateral loans and unsecured loans work primarily the same way. You’ll be required to fill out a loan application detailing how much funding you’re requesting, what it will be used for and sharing your personal and financial details, like your employment history, proof of income and authorization to pull your credit score and history.
After you are approved for your loan, you’ll receive the funds and you’ll be on the hook to make monthly payments until the end of the term, or until the loan is paid off in full. After the loan is paid off, the term of your loan ends, even if you pay it off early.
The main difference between a secured collateral loan and an unsecured loan is that the asset you’ve pledged can be repossessed by your lender if you default on the loan. For example, if you put your car down as the asset against your loan and you stop making your payments, a tow truck can show up in your driveway to haul your car away.
Qualifying for a collateralized loan is easier than qualifying for an unsecured loan because the approval of your application is based on both the value of your asset and your credit worthiness says Michael Dinich, a Registered Financial Consultant from Sayre, Pa.
With an unsecured loan, your credit worthiness is mainly used to evaluate your application. This makes a collateral loan a better option if you don’t have a strong credit score.
You will have to prove the value of your asset to be used for a collateral loan and be able to prove ownership with a title for vehicles or property, or by having your name on the account if you pledge savings or an investment portfolio.
Dinich says specific criteria needed to qualify for a collateral loan will vary by lender and the amount of money you are attempting to borrow.
Types of collateral you can use to secure loans
As mentioned, there are many different types of collateral loans you can apply for different purposes.
Below is a list and summary of some of the most popular types of collateral loans, categorized by the asset used to back them.
Using your home as collateral for a loan is common. A few types of loans that may use your home as collateral include:
- A new mortgage loan
- Refinancing an existing mortgage
- Taking out a second mortgage
- Home equity line of credit (HELOC)
Loan terms on a traditional mortgage or mortgage refinance can vary from 15 to 30 years. The length of the loan, along with many other factors, will affect the interest rate you receive.
Using your home to secure a loan is something that should be carefully considered to ensure you have the ability to pay the loan payment each month. If you default and your home is foreclosed on, you could find yourself living on the street.
Auto loan. Most commonly, your car will be used to secure the auto loan against its purchase. But, if your car is already paid off, you may be able to use it as collateral against a personal loan instead.
The value of your car will help determine how much funding you can receive when you are using your car as the collateral for a personal or auto loan. The value of your car will be determined by the lender. It may be based on an estimate from a website like Kelley Blue Book, or by finding the sales prices on similar vehicles in your area.
Shop around at several different banks and credit unions to get the best interest rate and terms for your auto or personal loan. The rates can vary quite a bit depending on the lender’s policies.
Terms for auto loans can be as long as seven years, which will lower your monthly payment, but cost more in interest over the life of the loan.
Car title loans are also secured using your car as collateral. But in this case, you have to surrender the title of your car to the lender in order to get your funds for a short term of 15 to 30 days. The interest rates on car title loans tend to be very high, in the triple digits, so you should avoid them if possible.
Investments and savings
Using your investment account as collateral on a loan can be a bit more tricky, especially if you want to use a tax-deferred investment, like an annuity, as collateral for a loan.
“Before you use your annuity, ask the bank how they will file the paperwork, and check with your annuity to make sure you can use it as collateral,” said Dinich.
The reason is because tax-deferred investments may be subject to tax penalties if they are used as collateral on a loan.
“That would be a double whammy,” said Dinich. “You’d be paying interest to the bank, as well taxes on the annuity interest.”
That said, banks and credit unions do offer loans on nonqualified investments, such as:
- Savings and Certificates of Deposits (CDs)
- Mutual Funds
- Money Markets
- Qualified investments, which are pre-tax investments like 401(k)s, 403(b)s, IRAs, etc.
Dinich said one reason people may get a loan against their savings or investments is to help build their credit history.
Similarly, Dinich says you may be able to borrow against the cash value of your life insurance policy.
“Some people buy cash-value life insurance just to have the option to borrow against it later,” says Dinich.
According to Dinich, this concept is also known as “infinite banking”. The interest paid during the loan term will be put back into the cash value of the insurance policy.
Although it may sound counterproductive at first, banks and credit unions will also loan money against your savings account balance as collateral.
“Some people wonder why you should borrow against your savings if you have the money,” says Dinich. “But, there are a few instances where it makes sense.”
One example given by Dinich is if your bank or credit union offers perks based on your savings account balance, such as a lower rate on a mortgage loan if your savings balance is $20,000 or greater.
Later, if you’re in a cash crunch, you may not want to take money out of your savings account if it would put you below the $20,000 threshold. Instead, you might decide to take out a loan against your savings as collateral.
Dinich says taking a short-term loan against your savings could also be a way to build or establish credit.
Future paychecks are most often used as collateral for payday loans. This is the most costly type of collateralized loan available.
According to Dinich, the interest rates can be as high as 400%.
“People get stuck in a cycle of being behind when they take out payday loans,” he said. “Then they have to pay fees on top of the interest in order to continue extending the term of their loan.”
Dinich said payday loans should only be used as a last resort in an emergency. If you must use your future paychecks to secure a payday loan, you should shop around to find an honest and reputable lender, and not be afraid to ask questions.
“The commission rate paid to sales people for payday loans is high, which can make them become pushy and try to hide the fine print about interest rates and fees,” said Dinich.
As an alternative, Dinich says to ask friends and family for a short-term loan, or seek assistance programs available from some employers who may give an advance on your paycheck.
Alternatives to secured personal loans
In addition to secured personal loans and the other types of loans listed above, you may consider trying to improve your credit history and reapply for an unsecured personal loan.
Keep in mind that an unsecured personal loan may have a higher interest rate than a secured loan, and you may be limited to borrowing a smaller amount of money. This is because unsecured loans are riskier for lenders.
As low as 2.49%
Minimum 500 FICO®
24 to 60
LendingTree is not a lender. LendingTree is unique in that you may be able to compare up to five personal loan offers within minutes. Everything is done online and you may be pre-qualified by lenders without impacting your credit score. Terms Apply. NMLS #1136.
As of 17-May-19, LendingTree Personal Loan consumers were seeing match rates as low as 2.49% (2.49% APR) on a $20,000 loan amount for a term of three (3) years. Rates and APRs were based on a self-identified credit score of 700 or higher, zero down payment, origination fees of $0 to $100 (depending on loan amount and term selected). Terms Apply. NMLS #1136
If your credit card has a high enough limit, you may also be able to use it instead of taking out a new loan. However, the interest rate on your credit card is likely to be higher than most secured loan options. If you have poor credit, you may be able to qualify for a secured credit card to help build your credit history.
Another option to consider is to take out a loan from your 401(k) directly. This is not a collateralized loan in the sense that you will forfeit your 401(k) assets if you don’t pay back the loan. You are effectively borrowing from yourself. This can be advantageous because the interest paid on the loan will be put back into your 401(k) as you’re paying yourself to borrow money. However, there are other risks to consider. You’re going to miss out on potential growth for any funds you pull out your 401(k) and if you’re fired or leave your job, your loan will likely come due immediately.
Before you opt for any of the choices in this article, make sure you’re being smart with your borrowing. Don’t take on more debt than you afford to pay. Missing payments will not only harm your credit score and make it more difficult to qualify for a new loan in the future, but if you have a collateralized loan, your assets could also be seized to help pay back the loan.
You should also take your time to shop around for the best lender and product to fit your needs. Don’t be afraid to ask questions about any loan product before you apply. If any lender is too pushy, it’s a red flag.
The bottom line
Collateral loans aren’t your only option for getting funding. But, if you can’t qualify for an unsecured personal loan, they may be a good thing to consider.