What is a Collateral Loan?
A collateral loan is a secured loan. It is a loan that requires borrower's property as collateral. The pledge acts as a guarantee that the borrower will repay the loan in full. If the borrower has problems with payments, the property deposited as collateral becomes the property of a bank, lender, or other financial institution. Secured loans usually offer a lower interest rate and a larger loan amount compared to unsecured loans, as they pose less risk to the lender. A secured loan is also a suitable option for those borrowers who cannot be qualified for unsecured loans due to bad credit or insufficient income.
Types of Collateral Loans
- Vehicle Loans. A vehicle loan, also called an auto loan, is a secured personal loan intended to purchase a car for personal use or transport for business. The pledge for the auto loan is the car itself. The car purchased by the borrower on credit is the property of the credit union until the borrower pays the lender the entire amount of principal and the amount of interest. As in any collateral loan, if the borrower loses the ability to pay the loan, the lender sells the transport to avoid losing money.
- Mortgage Loans. A mortgage is a loan for the purchase of the real estate. The borrower applies to the credit union, and they buy the property desired by the borrower. Further, the borrower pays this amount plus interest in equal monthly payments for 15 to 30 years. There are many types of mortgages. Some types of such loans are guaranteed by government organizations and have more flexible credit conditions. These mortgages include FHA loans, USDA loans, and VA loans. A mortgage can have both a fixed and a variable interest rate. If the borrower defaults and cannot pay the mortgage, the lender sells the property.
- Secured Credit Cards are a kind of a personal loan that allows the borrower to have a credit card with a maximum credit line corresponding to the borrower's security deposit. This credit card is suitable for borrowers with a low credit score, since if the borrower makes a deposit, it reduces the lender's risk. Before opening the card, the borrower makes a security deposit, and they borrow money from the credit limit. Further, the cardholder pays the debts every month before the start of a new billing cycle.
- Pawnshop Loans. A pawnshop loan is a loan that is issued by a pawnshop. The borrower brings the property as expensive equipment, jewelry, and other valuables to the pawnshop, and the pawnshop, after assessing the value of the thing, issues the borrower a loan for the amount of the property value. The pawnshop sets the deadline by which the borrower must redeem the thing from the pawnshop, which is a pledge. Otherwise, the borrower's property will become the property of the pawnshop. If the borrower does not buy the value back, then the pawnshop sells it at a cost higher than the loan amount.
- Bad Credit Loans. A bad credit loan is a secured loan that is specially created for borrowers who cannot be qualified for an unsecured loan due to limited credit history or its absence or due to a low credit score. Bad credit loan is a unifying concept for personal loans that have credit requirements lower than unsecured personal loans. When a credit union decides whether to issue a loan to a borrower, a high credit score is an indicator for them that the borrower will regularly pay the loan. With a bad credit loan, the borrower provides collateral as a guarantee of their solvency.
- Life Insurance Loans. A life insurance loan is a secured loan that allows a borrower to get a loan against their life insurance policy. Here, the cash value of the insurance is used as collateral for obtaining a personal loan. The borrower can later repay the loan amount or agree with the lender that the lender will receive the borrower's death benefit after their death instead of the beneficiaries. Thus, the borrower can take out a loan and not pay it during their lifetime. However, in this case, the borrower's relatives will not receive compensation in the event of the borrower's death.
- Home Equity Loans. A home equity loan, also called a second mortgage, is a loan against the value of the borrower's real estate. Credit union evaluates the value of the house and gives the borrower the entire amount of it once. The house becomes collateral, and the borrower risks losing the property in case of problems with payments. This loan is usually taken to pay medical bills, repair a house or install improvements. Such a loan is risky, and the borrower should consider it only in emergency cases.
Pros and Cons
Pros
- A collateral loan is easier to get to a borrower with bad credit. A secured loan is almost the only way for borrowers with bad credit to take out a personal loan for a considerable amount. A borrower with a bad loan but a high level of income can take out some types of personal loans by depositing collateral as a sum of money or property. If the borrower makes a deposit, the lender has a guarantee that the borrower will repay the loan.
- A secured loan offers an interest rate lower than an unsecured loan. The interest rate in unsecured loans depends on the borrower's credit score. The higher the credit score, the more confidence the borrower has, and the lower the interest rate. With a secured loan, the borrower can gain the lender's trust by making collateral of great value. Unlike the credit score, which is only an indicator that the borrower has regularly repaid loans in the past, the real collateral is a more suitable guarantee for the lender. Therefore, secured loans have lower interest rates.
- Secured loans offer a larger loan amount. Lending a large amount is a risk for the lender. The higher the loan amount, the greater the risk. Because a secured loan requires real valuable collateral, credit unions can take such a risk. Therefore, usually secured loans offer a loan amount more than unsecured loans.
- This loan is a good option for credit builders. Borrowers with a damaged credit history, low credit score, or no credit history can use collateral loans as starting loans to restore or build credit. For example, secured credit cards rarely have credit requirements, but proper handling of a credit card has a positive effect on credit history. By taking advantage of this, borrowers can improve their credit.
Cons
- The risk of losing property in case of problems with payments. The main drawback among all cons of collateral loans is the risk of losing money or property used as collateral. When a borrower applies for a secured personal loan, they need to be sure that in the future, they will not have problems paying off the loan. This is especially important to consider for borrowers who take a loan secured by their real estate. In such loans, there is always a risk of property loss since it is impossible to know in advance what financial problems may arise.
- The application process is more difficult. Besides filling out an application for a collateral loan, the borrower also needs to go through assessing the property. Usually, credit unions hire independent appraisers who estimate the cost of collateral, and based on this cost, the lender issues a loan to the borrower. The evaluation of the borrower's property makes obtaining a loan long.
What is used as a collateral
The list of things that can be used as collateral is quite extensive:
- Jewelry;
- Real estate;
- Savings account;
- Retirement account;
- Investment portfolio;
- Personal assets;
- The car;
- Insurance policies.
A collateral loan is an extensive concept that includes many types of personal loans. Each type of loan requires its type of collateral. For example, a mortgage and a home equity loan cannot be taken with any other collateral other than real estate.
Legal regulations of collateral loans
Collateral loans, like all personal loans, are regulated by the state organization Consumer Financial Protection Bureau (CFPB).
This organization regulates the activities of landers, the honesty of credit conditions, and the equality of borrowers regardless of demographic data. The CFPB is also engaged in preventing the dishonest treatment of borrowers by banks and other financial institutions. This bureau accepts complaints and proposals from borrowers and deals with their consideration.
If we consider the mortgage, then this type of loan is regulated by numerous legal acts such as the Truth in Lending Act (TILA), Ability-to-repay/Qualified Mortgage (ATR/QM) and the Real Estate Settlement Procedures Act (RESPA).
When choosing a lender for a mortgage, the borrower should pay attention to the postscript "Equal Housing Lender", since this means that the lender does not discriminate against borrowers on any basis, so this lender can be trusted.
How to Get a Collateral Loan
There are several important aspects that a potential borrower should consider before applying for a collateral loan.
The most important factor when choosing a suitable credit option is the interest rate. Most personal loan lenders, even issuing a secured loan, set an interest rate based on the borrower's credit score. A potential borrower should pay attention to what minimum and the maximum interest rate the lender offers. It is best to look for a credit option with the lowest minimum interest rate.
It is also worth paying attention to additional fees. The lender can have late fees, application fees, prepayment penalties, and overdraft fees. Secured credit card issuers can have balance transfer fees and foreign transaction fees. The borrower should make sure that all fees have a small size. Most online lenders do not have application and prepayment fees, but some lenders still require them.
Another important factor is the loan term. The borrower needs to look for a lender who offers the most suitable loan term. They need to be sure that monthly payments will not be too high for them. The longer the loan term, the less amount per month the borrower will need to pay.
To compare different loan offers, the borrower needs to get pre-qualification from multiple lenders. Pre-qualification only requires a soft credit check, so it will not harm the borrower's credit score. Having received several pre-qualifications, the borrower can compare all the credit conditions in more detail since the conditions presented in the loan agreement are based on the borrower's credit score.
Each type of secured loan has its credit requirements. However, it is possible to say that most of these loans require a not-too-high minimum credit score. Even a mortgage can be obtained with a 580 credit score. Such borrowers can get a mortgage guaranteed by the FHA. Usually, fair credit is enough to get a secured loan.
The rules regarding the age and citizenship of the borrower are common. The borrower must be at least 18 years old and be a citizen and permanent resident of the United States. To confirm the identity of the borrower, the lender may ask to upload a driver's license, passport, or state-issued ID.
The borrower's income requirements are also similar for almost all lenders. The borrower must have a stable source of income that already brings them income for at least 2 years. The borrower's debt-to-income ratio should not exceed 45%. To confirm the borrower's income level, landers are usually asked to download pay stubs, tax returns, W-2s, or bank statements.
To apply for a collateral loan, the borrower needs to go to the lender's website and click on the "Get Started" or "Apply Now" button. Next, the borrower needs to enter personal information such as name, SSN or ITIN, phone number, email, residential address, state, and ZIP code. A potential borrower also needs to choose whether they rent housing or have their own and what amount per month is spent on it. In the next window of the form, they need to fill out the information about the employment status, the employer's phone number, and the position held at the place of work. Next, they need to enter the amount of annual income before taxes. After receiving the approval, the loan officer will contact the borrower to coordinate further actions such as property valuation and signing of the loan agreement.
