Everything You Need to Know About Collateral Loans

When you need cash for a major expense, it might be tempting to max out a credit card. But you have other options that aren’t as likely to harm your credit or put you in a cycle of debt — even if your credit isn’t all that great.

Collateral loans could be a way to borrow the money you need. Here’s how they work.

What Are Collateral Loans?

When you take out a loan from a bank or other financial institution, it’s one of two things: secured or unsecured. You can secure the loan by pledging something with significant value in case you default — this is called collateral. An unsecured loan is when you borrow money without any collateral to back the loan.

With a secured loan, the lender can take possession of the asset you put up as collateral if you’re unable to pay the loan back. This presents a bigger risk to you as a borrower, but it decreases the risk on the lender’s part. For this reason, secured loans can be easier to get approved and can also be less expensive.

According to James Garvey, CEO and co-founder of Self Financial, a company that offers credit-builder loans, collateral loans are best for those who need short-term liquidity. However, he notes, “You need to own your car, house or other valuable asset” to borrow against.

Common Types of Collateral Loans

Any type of loan can be a collateral loan. These are the categories most collateral loans fall into.

— Mortgage. One of the most common types of secured loans is a home loan, also known as a mortgage. Collateral loans on property are backed by the real estate that you are financing. If you miss payments, the loan can go into default, in which case the lender forecloses on your home and sells it to recoup its losses.

— Home equity loan. A home equity loan is similar to a mortgage, except that the loan is secured by the home’s equity, or the difference between the home’s current value and the amount still owed on the mortgage. This type of loan is also known as a “second mortgage” and allows you to borrow against your equity.

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— Vehicle loan. If you take out a loan to finance a car, truck, boat, motorcycle or even private plane purchase, that loan is secured by the vehicle. Similar to a mortgage, failing to pay back the loan can result in having that vehicle repossessed.

— Secured personal loan. Personal loans can be used for a variety of reasons, such as paying for a big-ticket item or consolidating credit card debt. Both secured and unsecured personal loans are available from lenders. With a secured personal loan, putting up collateral will get you better interest rates and terms. There are a variety of assets you can use to secure a personal loan with collateral, including cash, a vehicle, stocks and bonds, jewelry, collectibles and more.

[Read: Best Mortgage Refinance Lenders.]

Pros and Cons of Collateral Loans

Though using a collateral loan can be an effective way to borrow money, there are some risks that don’t exist with other types of loans. The major advantages of a collateral loan are:

— You’re more likely to be approved. If you’re having a tough time getting a loan, perhaps due to credit issues or a short credit history, securing a loan with collateral could help reduce your risk as a borrower.

— You might qualify for a larger loan. Similarly, since you are reducing the lender’s risk by offering up collateral, you might qualify to borrow more than you would otherwise.

— It provides short-term liquidity. If all of your money is tied up in assets that aren’t easy to convert into cash, such as a home or valuables, a collateral loan can help you get your hands on money without having to go through the cumbersome process of selling those assets.

On the other hand, there are some disadvantages to collateral loans:

— You can lose the collateral if you don’t pay the loan back. The biggest risk of a collateral loan is you could lose the asset if you fail to repay the loan. It’s especially risky if you secure the loan with a highly valuable asset, such as your home.

— It requires you to have a valuable asset. Another potential issue is that you must have something valuable to offer as collateral in the first place. With an unsecured loan, you can borrow money without offering anything in return — except your credit score. If you’re unable to qualify for an unsecured loan, it might be tough to come up with the collateral necessary to secure a loan instead.

Adham Sbeih, CEO and co-founder of Socotra Capital, a real estate lending and investment firm based in Sacramento, California, also says you should look out for prepayment penalties, which are fees charged by the lender if you want to pay off the loan before the term is up. “Make sure you have an exit strategy,” he says, since these loans are not intended to be a permanent solution to cash flow issues. You should have a specific goal for your collateral loan, as well as a plan to pay it off.

What Can You Use as Collateral?

When it comes to the type of assets you can use as collateral, the easier it is to value and turn into cash, the better. So for example, a lender would likely accept a savings account or car as collateral, while your great-aunt Sally’s china set might be a tougher sell. Even so, a variety of items can serve as collateral. It all depends on the particular lender’s requirements.

As far as common forms of collateral go, cash in a bank account, such as a savings account or certificate of deposit, usually works well since the value is clear and the funds are readily available. Garvey says you can use a car, house, jewelry or other valuable asset as long as you’re the owner. Life insurance policies with a cash value may be accepted. However, funds in retirement accounts, such as your 401(k) or individual retirement account, are generally not accepted.

In the case of business collateral loans, lenders might accept machinery or other types of equipment, as well as future receivables as collateral. You may have the option, or may be required, to offer up personal assets as collateral, but that can be risky.

Where to Find Collateral Loans

Most financial institutions offer collateral loans. However, the terms and interest rates might vary. If you’re not sure where to start your search, consider these types of lenders:

— National banks. Large banks, which tend to offer the widest variety of financial services, are known for their convenience. Borrowing from a national bank can be a good option if you’re already a customer or there aren’t any other convenient options near you.

— Community banks. Smaller local banks are more likely to work with local customers. They have to compete with larger banks for business, which means they may offer more competitive terms on deposits and loans.

— Credit unions. Another type of community financial institution, credit unions are nonprofit financial co-ops that are owned by their members. Therefore, they are also great places to find collateral loans with lower rates and more attractive terms. To join a credit union, you usually have to live, work, go to school or attend religious services within its field of membership and maintain a savings or share account.

— Online lenders. Finally, online banks could provide access to borrowing opportunities that don’t exist locally. Plus, because they operate exclusively via the web and have little overhead, online banks may be able to lend at lower rates. Look for lenders that will let you prequalify to check your potential interest rates and terms before submitting an official application. That way, you can see what your options are without incurring a hard credit inquiry.

[Read: Best Online Banks.]

How to Apply for a Collateral Loan

If you think a collateral loan is the right option for you, be sure you get approved by following these important steps:

1. Check your credit. Securing a loan with collateral can help you get approved for a loan even when your credit isn’t excellent. However, it’s still worthwhile to make sure your credit is as good as it can be to get the lowest collateral loan rate and best repayment terms. You can pull your credit reports for free at annualcreditreport.com; check them for errors or any negative marks that you need to fix before applying for a loan, such as a past due payment.

2. Choose your collateral. If you are applying for a home or auto loan, the collateral backing your loan will be the property you’re financing. However, if you are taking out a secured personal loan, you have options. Determine which assets you have available to secure your loan and try to choose those that are liquid and easily accessible, such as funds in a bank account.

3. Gather your documentation. Once you’re ready to apply, it’s helpful to gather up all the documents and information you’ll need ahead of time. Some information you can expect to be asked for includes: personal details, including your name, birthdate, Social Security number and driver’s license or other government-issued identification; proof of income and assets, such as W-2 forms, pay stubs, recent tax returns and bank statements; list of liabilities, such as existing debt payments, monthly rent or mortgage payment, child support or alimony payments and other monthly obligations.

4. Shop around for the best collateral loan rates. Before you go through the full application process, it’s important to get quotes from several lenders and compare the collateral loan rates and terms. You can easily get quotes online, which typically only require a soft credit check and won’t impact your credit.

5. Choose your lender and apply. Once you find an offer that fits your budget and needs, you can go through with the full application process. Note that officially applying for a loan will result in a hard credit check, which is noted on your credit reports. However, it should have a temporary and minimal impact on your credit score.

Collateral Loan Alternatives

Though it can be easier to borrow money if you secure the loan with collateral, you might not be comfortable risking your assets — or you might not have any. If that’s the case, you do have a few other options:

— Unsecured personal loan. It’s possible to obtain a personal loan without putting up collateral. This is known as an unsecured loan since you don’t back it with anything of value. Instead, you sign a contract stating that you will pay the loan back according to the terms. And, of course, if you don’t, your credit rating will take a hit. The drawback to unsecured loans is the qualification requirements are often stricter, and interest rates can be higher since it’s a riskier loan for the lender.

— Credit-builder loan. If you can’t qualify for a secured or unsecured loan because your credit isn’t good enough, all is not lost. With a credit-builder loan, a financial institution — usually a credit union — will deposit money in a bank account for you and hold it until the end of the loan term. You pay the institution back for the deposit in installments. Once the term is up and you’ve paid it back, you get the cash. Your credit activity will be reported to the credit bureaus. However, this type of loan doesn’t offer immediate access to funds.

— Friend or family member. Finally, you might consider borrowing money from someone you know rather than risking your assets and credit on a loan. Of course, this presents its own challenges, since you can also risk your relationship should you not be able to pay the person back. It’s up to you to determine if borrowing from friends or family is a realistic option.

[Read: Best Personal Loans.]

Are Collateral Loans Worth It?

Collateral loans come with some risk, since you could lose the asset you use to secure the loan if you fail to make payments. However, if you’re on solid financial footing, a collateral loan can be well worth it. Securing a loan with collateral offsets some risk by allowing for lower interest rates and fees. That can save you quite a bit of money in the long run.

Casey Bond is a seasoned personal finance writer and editor. Her work has appeared in a number of major national publications including U.S. News & World Report, Yahoo Finance, MSN, The Huffington Post, Business Insider, Forbes and others. Follow her on Twitter @CaseyLynnBond.