A collateral generally refers to a valuable asset, such as a house or a car, which a borrower or debtor pledges as security for a loan. Because of this, a collateral loan, i.e., a loan that uses a collateral, is also known as a secured loan.
Technically speaking, a collateral is a contractual device that protects the lender or creditor if the borrower or debtor ever defaults on paying their loan. That is, if the borrower does not pay the agreed-upon payments, then the lender has the right to seize those assets.
So, a collateral serves a dual purpose. First, it makes it easier for debtors to borrow money, although they bear the risk of losing the collateral if they don’t repay their loan. But, that risk is typically balanced out by lower interest rates or larger loan amounts. Secondly, a collateral removes the risk for lenders of not getting anything back for a loan they lend out.
If you’re planning to apply for a loan with collateral, these are the general steps you should follow.
Assess Your Creditworthiness
Before anything else, it’s best to evaluate your credit score. Check if there are any errors or negative marks that need fixing. This step is essential whether you’re applying for a secured or unsecured loan.
Doing this step ensures that your credit score is as good as it can be so that no matter which lender you end up applying from, you have a higher chance of getting a low collateral loan rate and good repayment terms.
Choose Your Collateral
Once your credit score is as good as it can be, the next item on your to-do list is to think about what your collateral should be. This often depends on the type of loan you’re looking to get.
For instance, if you’re planning to buy a house, the collateral for a mortgage is the house. If you’re in the market for a new car, the security for the loan would be the vehicle.
Other collateral loans will require assets that are liquid and easily accessible. For instance, if you could offer the funds in your bank account as security for a loan.
These are the common types of collateral that most lenders consider for a secured loan:
- Real estate
- Vehicles
- Business equipment
- Inventory
- Invoices or accounts receivable
- Blanket lien, or the total value of your business assets
- Savings account or certificate of deposit (CD)
- Investments
- Cash
- Other valuables, such as jewelry, antiques, art, collectibles, and insurance policy
Shop Around
There are many lenders that could grant you a collateral loan, including banks, credit unions, pawn shops, and online lenders. However, they might have different loan rates and terms.
So, before sitting down to fill up an application form for a collateral loan, do your due diligence. Research the rates and loan terms of various lenders.
You should get quotes from several lenders. Review and compare the following before deciding on the lender you’ll apply with:
- Credit score and income requirements for the loan
- Minimum and maximum loan amounts
- Type of collateral required
- Interest rate and annual percentage rate (APR)
- Loan interest rate (fixed or variable)
- Fees and other charges, such as origination fees and prepayment penalties
Prepare Your Documents
Once you’re ready to apply, you’ll need to gather all the necessary documentation for your loan. The requirements might vary depending on the lender and collateral.
In addition to your name, birthdate, social security number, and other personal details, lenders might also ask for your driver’s license or other government-issued ID. They might also request for your W-2 forms, bank statements, pay stubs, recent tax returns, and other proof of income and assets as well as a list of liabilities. So, any existing debts and other expenses, such as rent or mortgage, child support, or alimony payments, which could affect your ability to pay for a new loan.
Submit Your Loan Application
When you have prepared all the required documents, then you can submit a loan application to your chosen lender.
Once they have received your loan application, the lender will have to assess the value of the asset you’re pledging as a collateral. This is the collateral application process.
Should they approve your loan, the amount will be dependent on the fair market value of your collateral. The loan amount is typically a percentage of the collateral’s value.
If they find no issue with your collateral, they will then offer you a loan. You should review the loan agreement and then sign it. Then you’ll just have to wait to receive the loan amount.
Pros and Cons Securing a Loan with Collateral
Taking on a collateral loan has its advantages but also disadvantages. It’s best to weigh both the benefits and risks before getting a secured loan.
Advantages or benefits of a loan with collateral
For borrowers with below-average credit scores, it can be hard to borrow money from anywhere. However, if you have collateral as security, you have a higher chance of getting approved for a loan. Having a collateral cushions the risk lenders take in order to give you credit.
Not only that but you might even qualify for a larger amount than you would have if you did not put up the collateral for security. Of course, how large the loan amount is depends on your collateral and its value. Lenders might also lower the interest rate because of your collateral.
Disadvantages or risks of a loan with collateral
A big disadvantage of secured loans is the requirement of a collateral. Not everyone has a valuable asset to put up as security for a debt, so this limits who are able to borrow.
Of course, there is also the risk of losing your collateral in the event that you are not able to pay the agreed-upon installments. If you put your house as collateral, for instance, you run the risk of losing your home if you can’t pay back the debt.
You might also find that with collateral loans, there is more red tape during the application process as well as additional fees or charges like prepayment penalties.
That is why, collateral loans should only be a temporary fix to your cash flow issues. You should have a specific goal for acquiring this debt and a plan to pay it off.