What Is a Collateral Loan?

Ever been asked to put something up as collateral and wondered what it actually means? If you’re asking, “What is a collateral loan?” you’re not alone. In simple terms, collateral is something valuable you agree to use to secure a loan. When a loan is backed by collateral, it’s called a secured loan. It could be your car, money in savings, or another asset you own.

So why would you want to put an asset on the line? For some people, collateral can make it easier to qualify for a loan or help them get a lower interest rate. And for people with a less-than-perfect credit history, it can be especially helpful when trying to qualify for a loan. But using collateral comes with a trade-off. If you don’t repay the loan, you could risk losing the asset you used as collateral.

Focus Federal Credit Union breaks down how collateral loans work, the benefits and risks, and how to decide if one might be right for you.

What Is a Collateral Loan?

A collateral loan is a type of loan backed by something you own. The asset is called collateral, and it gives the lender added security when lending you money. You may also hear a collateral loan called a secured loan. The terms essentially mean the same thing: you’re using an asset to secure the money you’re borrowing.

Depending on the loan, collateral could be a vehicle, money in a savings account, a home, or another asset. With a collateral loan, the lender has a legal claim, or lien, on the asset you use as collateral until you pay off the loan. If you repay the loan as agreed, you keep the asset.

How Collateral Loans Work

A collateral loan uses an asset you own to secure the money you borrow. When you apply for the loan, the lender assesses the value of your collateral to determine how much you can borrow. This is often called the loan-to-value ratio, or LTV.

For example, if you use a car worth $10,000 as collateral, a lender may allow you to borrow a percentage of its value rather than the full $10,000. The amount you can borrow will depend on the lender, the type and value of the collateral, and other factors, including your credit and income.

Once the loan is approved, the lender places a lien on the collateral. You can keep using the asset while making your payments. When you pay off the loan, the lender releases the lien. But if you stop making payments and the loan goes into default, the lender may have the right to take possession of the collateral. With a vehicle, for example, this could mean repossession.

Common Types of Collateral 

Collateral isn’t limited to one type of asset. Depending on the loan and lender, you may be able to use a vehicle, savings, home equity, or other valuable property as collateral.

Types of collateral used for loans are:

• Vehicle. When you finance a new or used car or truck, the vehicle itself typically serves as collateral for the loan. You can use the vehicle while making your payments, and the lender holds a lien on it until the loan is paid off.
• Vehicle Title. A car title loan uses a vehicle title as collateral. These are typically short-term loans and are a type of vehicle-secured borrowing.
• Savings. A savings-secured loan uses money in a savings account or share certificate as collateral. The funds remain in your account while they secure the loan, although you may have limited access to some or all of them until you pay it off.
• Home Equity and Home Equity Lines of Credit (HELOCs). A home equity loan provides a lump sum you repay over time, while HELOC provides a revolving line of credit you can draw from as needed.
• Other Collateral. Depending on the lender and loan type, you may also use other valuable property as collateral, such as a boat, RV, or other recreational vehicle.

Benefits of Collateral Loans

A collateral loan can offer several advantages, especially if you have limited or less-than-perfect credit history. Because collateral gives the lender additional security, secured loans may come with lower interest rates than comparable unsecured loans. A lower interest rate can mean paying less in interest over the life of the loan. Your credit history, income, loan amount, and other factors can also affect the rate you receive, so review the full loan terms before borrowing.

Collateral can give lenders additional security, which may make it easier to qualify for a secured loan than some unsecured loan options. Your credit history and other financial information still matter, but an asset securing the loan may give you more borrowing options if your credit isn’t perfect.

Because an asset backs the loan, secured loans may let you borrow more than you could with some unsecured loan options. For example, a vehicle with sufficient value may qualify you for a larger loan than you could get without collateral.

Risks to Understand Before You Borrow

A collateral loan can make borrowing more accessible, but you should understand what you’re risking. The biggest risk of a collateral loan is losing the asset you pledged to secure the loan. If you fall behind on payments and the loan goes into default, the lender may have the right to take possession of the collateral. With a vehicle-secured loan, for example, this could mean repossession of your car.

The specific rules for taking possession of collateral vary by loan. Before signing your loan documents, make sure you understand the payment terms, what constitutes a default, and what could happen if you can’t make your payments. Giving up the collateral may not always satisfy the entire debt. Depending on the loan and how much the lender can recover from the asset’s sale, you could still owe money. And just like an unsecured loan, a secured loan can affect your credit history. Late or missed payments may be reported to the credit bureaus and can negatively affect your credit.

Collateral Loan vs. Unsecured Loan: Which Is Right for You?

Whether a collateral loan or an unsecured loan is right for you depends on your financial situation, what you’re borrowing for, and what you’re comfortable using to secure the loan.

A collateral loan may make sense if you’re looking for a lower interest rate or if your credit history makes it harder to qualify for an unsecured loan. Pledging an asset may give you access to financing you might not otherwise qualify for or help you secure a lower interest rate. An unsecured loan may be a better fit if you don’t want to put an asset at risk or need access to funds without using an asset as security. Because there’s no asset securing the loan, an unsecured loan may have a higher interest rate.

Before choosing either option, compare the interest rate, monthly payment, fees, and repayment terms. Most importantly, choose a loan you can comfortably repay. The right choice comes down to balancing cost, qualification, and risk based on your individual situation.

How To Qualify for a Collateral Loan

Qualifying for a collateral loan involves more than offering an asset. The lender will consider the collateral’s value, your ownership of the asset, and your overall financial situation. Lenders typically evaluate the asset to determine how much you can borrow.

For vehicles and other titled property, you’ll generally need to show ownership and provide the appropriate title or ownership documentation. Although collateral gives the lender additional security, your credit history, income, and existing debts can still affect whether you qualify and what loan terms you receive.

Loan Options at Focus Federal Credit Union

A collateral loan may be a helpful option when you’re looking for affordable financing and have an asset you can use to secure the loan. A local credit union can be a good option for a collateral loan. It lets you talk with someone who can review your individual circumstances rather than relying solely on an automated decision.

At Focus Federal Credit Union, we’re here to help you understand your options. Whether you’re considering a collateral loan or simply have questions about borrowing, our local team can provide personalized guidance based on your needs.

Ready to explore your options? Contact Focus Federal Credit Union to talk with a member of our team and find the right borrowing solution for you.

Frequently Asked Questions

Can a collateral loan help build my credit?

Yes, a collateral loan can help you build credit if you make on-time payments. Most lenders report your payment activity to the credit bureaus, so a steady record of on-time payments can strengthen your credit history over time. 

What happens to my collateral after I pay off the loan?

Once you pay off a collateral loan, the lender releases its lien, and the asset is fully yours again. With a vehicle loan, the lien is removed from your title, and you’ll receive a clear title showing you own the car outright. With a savings-secured loan, the funds that were holding the loan become fully available to you again. If you’re not sure when or how the lien will be released, ask your lender before you sign so you know what to expect.