The pros and cons of collateral loans

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In a Nutshell

Securing a loan with collateral could allow you to borrow more money, and at a lower interest rate — even if your credit isn’t stellar. But if you don’t pay the collateral loan back as agreed, you risk losing whatever property you used as collateral.
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Everyone wants the best possible rate when they borrow money. Securing your loan with collateral could give you more borrowing power and a lower interest rate — even if you have less-than-perfect credit.

But collateral loans — also known as secured loans — come with some risks, too. Among them are shorter repayment periods and possibly losing your property if you don’t repay the loan as agreed.

Pros

  • Easier to get with lower credit
  • Often lower interest rates than unsecured loans
  • Larger loan amounts may be available
  • The potential to be good credit builders

Cons

  • Complicated application process
  • High risk if payments are not made on time


What is a collateral loan?

When you take out a collateral loan, you agree to give a lender the right to take the property that’s securing the loan — like a car, home or savings account — if you fail to repay it as agreed. This property is considered the “collateral” on the loan itself. There are pros and cons to consider before taking a collateral loan, which we’ll take a closer look at later in the article.

Common types of collateral loans

Mortgages, auto loans and secured personal loans are examples of loans that require some type of collateral.

Each of these loans uses something different as the collateral. Mortgages would use your home as collateral, as would a home equity line of credit. Auto loans would use your car, and secured personal loans may use money from a CD or savings account. There are even some loans that will use other high-value items as collateral, such as diamonds or other types of jewelry.

Pros of collateral loans

Collateral loans can be easier to get if your credit isn’t perfect.

Credit history may be less of an issue with collateral loans than it typically is with unsecured loans — because putting up your property to secure the loan can lower the lender’s risk. If you don’t have the greatest credit, or if you have limited credit history, a collateral loan could give you more borrowing options.

Collateral loans typically have lower interest rates than unsecured loans.

Lenders typically view collateral loans as less risky than unsecured loans. For this reason, lenders are generally more willing to charge a lower APR for collateral loans than you’d find with an unsecured loan.

Collateral loans may allow you to borrow more money.

Since you secure a collateral loan with an asset, you give lenders a way to recoup their money if you default on the loan. Because of this, lenders may be more willing to grant you a loan for a higher amount, depending on the value of your collateral.

Collateral loans could help you build credit.

If you have little to no credit history, a secured loan could be a way to improve your credit score and start building a strong credit profile — as long as you make timely monthly payments of the minimum amount or more. Just make sure the lender will be reporting your payments to the main consumer credit bureaus.

Cons of collateral loans

The application process can be more complicated than for an unsecured loan.

Lenders have to value your assets used to secure a collateral loan, so this might mean you’ll need to provide more information than you would for an unsecured loan. But the process — and how long that process takes — can vary by lender.

You may lose your property if you don’t make payments.

If you default on a loan, there are serious consequences. In the case of a collateral loan, if you don’t make your minimum monthly payments on time, the lender may end up repossessing the asset that you used to secure the loan as part of the loan terms, whether that’s your house, your car or your cash.

Alternatives to collateral loans

If you don’t want to risk your property to get a loan but your credit is making it tough to get an unsecured personal loan from a traditional bank, there may be other options.

  • Credit unions — nonprofit financial cooperatives owned by members — may have less-strict eligibility requirements for unsecured personal loans. Some credit unions even offer special programs for borrowers with poor credit history. Though you have to be a member of a credit union to qualify.
  • Online lenders may offer unsecured personal loans to a wider range of borrowers. These loans typically come with high interest rates, though.

Be sure to get informed about the ins and outs of getting a personal loan when you have rough credit. Your choice of loans may be limited, and the costs in interest rates and fees can end up sending even the most well-intentioned borrowers into a financial tailspin.

As another alternative, you might consider how a secured credit card could work for you, potentially giving you the flexibility of a credit line and a way to build credit when you have little or no credit history — or if your credit profile is too dinged up for you to get an unsecured loan.


Next steps

Your decision on whether a collateral loan is right for you will ultimately come down to a few things like your credit history, how much you want to borrow and what collateral you may have to secure a loan with.

No matter what type of loan you decide to apply for, it’s best to make sure you have a plan to repay the loan and then shop around for the best loan rate before applying.


About the author: Paris Ward is a content strategist at Credit Karma, providing readers with the latest news that will aid their financial progress. She has more than a decade of experience as a writer and editor and holds a bachelor’s… Read more.