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How Collateral Works And Types Of Collateral Loans

Rachel Burris5-minute read
April 02, 2022

It can be challenging to qualify for a loan because lenders want proof that you can repay it. By offering you funds, lenders take on risk. If you’re unable to pay back your loan, your lender is on the hook for your remaining balance. To help minimize the risk involved in loaning you money, lenders may ask you to provide collateral for your loan. Read this article to find out what collateral is and how it works.

What Is Collateral?

Collateral is a personal asset, which may be in the form of property, that a borrower uses as security for a loan. By putting up personal valuables, stocks, bonds, real estate, etc., to secure a loan, the borrow reduces the risk involved and provides the lender with financial protection.

How Does Collateral Work?

When obtaining a loan, a lender will ask that you provide some form of collateral that can act as a repayment in case you default on your loan. Every type of loan has different requirements for what can be used as collateral. However, for some loans, like mortgages, the item purchased with the loan is used as collateral.

If you default and are unable to repay the loan, your lender can seize whatever you used as collateral. After taking over your asset, your lender will sell it to recoup your loan’s outstanding balance.

What Are Collateral Loans?

A collateral loan, also known as a secured loan, is one that is guaranteed by some kind of collateral. When you obtain a secured loan, you offer a personal asset as assurance that you will repay the funds in full. By providing collateral, you agree to give your lender control of your asset if you fail to make your payments.

An unsecured loan, on the other hand, is not backed by collateral. As a result, you must have a very strong credit history to qualify. Since you don’t guarantee the loan with a personal asset, unsecured loans are far riskier for lenders. If you miss your payments and default on your loan, your lender will not be able to recover your outstanding balance.

Since secured loans involve less risk than unsecured loans, they also come with certain advantages. By putting up collateral, the borrower typically receives better terms, including higher loan amounts and lower interest rates. This loan option is also beneficial for borrowers who have a low credit score, as offering collateral often makes it easier to qualify for a loan.

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Types Of Collateral Loans

There are a number of different types of collateral loans that you can obtain. Each type is used for a different purpose and comes with its own terms. Here are some of the most common types.

Mortgages

A mortgage is considered a secured loan because you must offer your lender the property you’re purchasing as collateral. When your lender gives you the funds, they put a lien on your property. Once you pay off the mortgage in its entirety, the lien is considered satisfied and removed. However, if you don’t keep up with your mortgage payments, the lien enables your lender to seize your home and sell it to recoup their losses. 

Auto Loans

An auto loan works similarly to a mortgage. When you take out an auto loan, you provide the car you purchase as collateral to secure the loan. Once you pay off the loan, the car is yours, free and clear. However, if you are unable to repay the loan, your lender is able to repossess your vehicle.

Credit Cards

Although most credit cards are unsecured loans, there are some secured credit cards, which can be used to improve your credit. Secured credit cards are typically used by individuals who have bad credit or have not built up a credit history yet, as they can be guaranteed by a cash deposit.

The amount of money that you need to put up when you open your account is determined by your credit issuer based on your credit score and history. Your credit limit – how much you’re allowed to charge on your card – is the amount of cash you deposit upon opening your account. 

Collateralized Personal Loans

A personal loan is a type of financing that provides borrowers with the freedom to use the funds as they see fit. While there are a number of different ways you can use a personal loan, some of the more common ones include debt consolidation, home improvements, auto repairs and medical expenses.

For individuals who have poor credit, it can be challenging to qualify for a personal loan. Although it is somewhat uncommon, you can obtain a collateralized personal loan in such cases. To secure the loan, you must offer an asset that meets or exceeds the value of your loan amount. Your lender will help you determine what asset can be used as collateral.

This collateral will provide your lender with the assurance that you’ll pay back the loan in full. However, if you fail to, your lender can seize and sell your asset to recover the cost of your loan.

FAQs About Collateral

When it comes to borrowing funds, collateral can make all the difference in determining your qualification and terms. However, before you decide a secured loan is for you, let’s take a look at some commonly asked questions.

What Is The Difference Between Collateral And Security?

Although people sometimes incorrectly use these terms as synonyms, there is a difference between collateral and security. They are both assets that are used to guarantee a loan. However, securities are specifically financial assets, such as stocks and bonds.

Securities are more beneficial for the borrower than the lender. The reason they benefit the borrower is that even while the financial asset is used to secure the loan, the borrower can still profit by collecting dividends from it. Accepting securities to back a loan is riskier for the lender, as the financial asset can depreciate in value over time.

What Is Collateral Protection Insurance?

Collateral Protection Insurance is used to insure an asset that is being used as collateral for a loan. As part of the loan agreement, the borrower typically agrees to purchase CPI and add the lender as a lienholder on the policy. In the event that the asset is damaged – say, a home is flooded, or a car is totaled – the CPI then protects the lender against financial loss.

What Happens If I Default On My Loan And My Lender Seizes My Collateral?

If you default on your loan and the asset you put up for collateral is seized, your lender will sell the asset to try to recover the cost of your loan and any fees incurred in the process. If the sale of the asset is enough to pay off your debt and all related fees, your lender will provide you with any remaining funds. However, if the sale doesn’t generate enough, your lender may take legal action to try to get you to make up the difference.

Either way, your credit score will likely take a considerable hit as a result of defaulting on the loan. Furthermore, you may find it challenging and more costly to obtain a loan in the future. That’s why you should always reach out to your lender ahead of time if you think there’s a chance you may be unable to make your monthly payments.

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Bottom Line

Collateral is an asset that you use to secure a loan. It provides your lender with the assurance that you’ll repay the money borrowed in full. Loans secured by collateral are considered less risky for lenders because they give lenders the authority to seize and sell your asset if you miss your monthly payments and default on your loan.

To learn more about personal finances, browse more articles in our financial Learning Center.

Rachel Burris

Rachel Burris is a writer covering topics of interest to present and future homeowners, as well as industry insiders. Prior to joining Rocket Companies, she worked as an English teacher for the New York City Department of Education and a licensed real estate agent for Brown Harris Stevens. She holds a bachelor's degree in creative writing from Bucknell University, a postbaccalaureate certificate in psychology from Columbia University and a master's degree in English education from Teachers College, Columbia University.