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What Does Collateral Mean And How Does It Work?

February 15, 2024 7-minute read

Author: Dan Rafter

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There are two main types of loans: Those that are backed by collateral and those that aren’t.

Most of the bigger loans you’ll borrow will be backed by something that your lender can take if you stop making payments, anything from your house to your car. These are collateral loans and, because they pose less risk to lenders, they typically come with lower interest rates.

There is risk for you, though, in taking out a collateral loan. If you don’t make your payments on time, you could lose your house, car or whatever else you put down as collateral.

What Is Collateral?

Collateral is an asset that a borrower uses to secure a loan from a lender. When you take out a mortgage loan, your home is used as collateral. This means that if you default on your loan payments, the lender can take possession of your home through a legal process known as foreclosure. If you take out an auto loan, your car is your collateral: Your lender can repossess your car if you stop making your auto loan payments. Loans that use collateral are secured loans.

There are also loans that don’t require collateral, such as most personal loans and credit cards. These are known as unsecured loans. If you stop making payments on an unsecured loan, your lender has nothing to collect because there’s no collateral backing it.

Your lender can fine you for missing your payments on an unsecured loan. And if you stop making your payments completely, your lender can send your loan to a collection agency. However, a lender can’t foreclose on your home or repossess your car if you stop making payments on a loan not backed by any type of collateral.

How Do Collateral Loans Work?

There are two main benefits of collateral loans: They typically come with lower interest rates than unsecured loans, and you can usually borrow more money with them. This is because collateral loans are considered a safer investment for lenders.

Consider a mortgage: You are less likely to stop making payments on your mortgage because you don’t want your lender to start the foreclosure process and take ownership of your home.

Because your lender has an asset to seize if you stop paying, it’s more comfortable loaning you a larger sum of money at a lower interest rate.

In other ways, a collateral loan works the same as any other loan. You’ll pay your lender back with regularly scheduled payments, usually once a month, with interest. You’ll make these payments until you pay off your entire principal balance.

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Types Of Collateral Loans

Several types of loans require collateral. Here are some of the more common:

Mortgage Loans

When you take out a mortgage loan, your home serves as collateral. If you stop making your payments, you could lose your home through the foreclosure process.

Auto Loans

Auto loans work similarly to mortgage loans. Only with these loans, your car is used as collateral. Again, your car is safe as long as you make your payments until you pay off your auto loan, with interest. But if you stop making payments, your lender could repossess your car and take ownership of it.

Secured Personal Loans

Most personal loans are unsecured, meaning that lenders have no collateral to seize if you stop making your payments. But lenders do offer secured personal loans, though they are rare.

In a secured personal loan, you’ll offer some form of collateral. Usually, this will be money in a savings account or certificate of deposit. If you default on your loan payments, your lender will take the collateral that you’ve provided.

Because it’s backed by an asset, a secured personal loan is considered less of a risk for lenders. These loans, then, usually come with a lower interest rate.

Secured Credit Cards

Most credit cards are also unsecured. If you stop making your credit card payments, the bank issuing your card has no assets to seize. Instead, it can only take steps such as raising your interest rate or charging a late-payment penalty.

A secured credit card works differently. When you take out a secured card, you first deposit money with the financial institution issuing the card. That money serves as your collateral and your credit limit.

Say you deposit $700 with the bank. You can borrow up to $700 with your secured credit card. If you stop making your payments, your bank can take what it’s owed from your deposit.

Secured credit cards are easier to qualify for, again, because lenders have the safety net of your security deposit. Consumers with lower credit scores often apply for secured cards. If they make their card payments on time, they might improve their credit scores enough so that they can apply for a traditional, unsecured credit card.

Pros And Cons Of Collateral Loans

As with all loans, there are positives and negatives associated with collateral-backed loans.

Pros

  • High credit limits: Loans backed by collateral tend to come with higher credit limits. With an asset such as your house or car backing the loan, lenders are more comfortable lending you a greater amount of money.

  • You can qualify with a lower credit score: Lenders may be willing to qualify borrowers with lower credit scores because they have the option to take a valuable asset should they stop making payments.

  • Lower interest rates: Loans are less risky if lenders have an asset to seize if you default. With unsecured loans, lenders make up for the higher risk by charging higher interest rates.

Cons

  • You might lose a valuable asset: If you stop making your payments – even if you suffer a job loss or a drop in monthly income that is out of your control – your lender can seize your house, car or whatever other asset you put up as collateral. Make sure that you can afford your monthly payment, even if your income takes a temporary dip.

  • A lengthier application process: Applying for a mortgage, auto or other collateral loan is not a quick process. Your lender’s underwriting team will determine how much of a monthly payment you can afford. This process can take 30 days or more. Your lender might have to place a value on the asset that you’re using as collateral, which could make the process take even longer.

How To Apply For A Collateral Loan

Applying for a collateral loan takes time. But if you follow the steps below, you can erase at least some of the stress from the process:

1. Check Credit Score And History

Before applying for a collateral-based loan, you should check your credit reports and three-digit credit score.

You can order free copies of your three credit reports – each maintained by the credit bureaus of Experian™, Equifax® and TransUnion® – once a year from AnnualCreditReport.com. These reports will list your open credit card and loan balances and any late payments that you’ve made or foreclosures you’ve gone through in the last 7 years. The reports will also list any bankruptcies you’ve declared in the last 7 - 10 years.

Check these reports for any errors, such as reported late payments that you know you paid on time or loans that you don’t remember taking out. Correcting an error in your credit reports could give your credit score a boost.

You should also check your three-digit credit score. This score tells lenders how well you’ve managed your credit or paid your bills in the past. The higher your score, the better your odds of qualifying for a loan with a lower interest rate.

It’s important to check your credit and score before you apply for a collateral loan. That way you’ll know if you need to improve your credit score before applying so that you can qualify for a lower interest rate.

2. Get Preapproved

Getting preapproved by a lender is another important step. During the preapproval process, a lender will review your credit and income to determine how much of a loan you can afford. You’ll provide your lender with copies of documents such as your last two paycheck stubs, last 2 months of bank account statements, last 2 years of tax returns and last 2 years of W-2 statements. Your lender will then use these to verify your monthly income.

Your lender will also provide you with a preapproval letter stating that they’re willing to give you a loan for a specific amount. This is useful if you’re looking for a home: You’ll know after your preapproval how expensive a home you can afford to buy.

3. Compare Offers And Lenders

You don’t have to take out your loan with the lender that gives you a preapproval letter. You can compare offers from different lenders before submitting a final loan application. This is a smart move. You might find a lender that’s willing to give you a lower interest rate, something that could reduce your monthly payment. You might also find a lender that charges lower closing costs, which are the fees that lenders and other providers charge for originating your loan.

4. Collect Documents And Submit Application

Once you’re ready, you’ll complete an application, providing your name, Social Security number and address. You’ll also need to provide estimates of your monthly income and debts.

Your lender might also require that you re-submit copies of documents to verify your income, even if you already provided these documents during the preapproval process. Lenders that have already preapproved you for a mortgage might want to make sure that your income levels haven’t changed. If that happens, you may be asked to provide an updated pay stub prior to closing. And if you’re working with a new lender, that financial provider will want to verify your income on its own.

5. Receive Money

After you submit your application, your loan will enter the underwriting phase. During this time, underwriters determine if you can afford to repay the money you’re borrowing. If these underwriters determine that you’re a good risk to make your monthly payments on time, you’ll be approved for the loan. If you’re taking out a mortgage loan, you can move into your new home. If you applied for an auto loan, you’ll be able to complete the purchase of your car.

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The Bottom Line

When you’re financing a major purchase – such as when you’re buying a home or car – you’ll typically apply for a collateral loan. These loans are attractive because of the lower interest rates and longer terms that they typically provide. Just be careful to make your payments on time. If you don’t, you could lose your collateral, whether that’s your home or car.

If you’re ready to apply for a collateral-backed loan, get started with Rocket Mortgage® and speak with a Home Loan Expert today!

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Dan Rafter

Dan Rafter has been writing about personal finance for more than 15 years. He's written for publications ranging from the Chicago Tribune and Washington Post to Wise Bread, RocketMortgage.com and RocketHQ.com.