When it comes to being approved for a loan it’s all about the risk, every lender has their own way of assessing risk based on credit history, credit scores, employment etc. If your potential lender finds that you are in fact a risky borrower you may be asked to put up some type of collateral to secure the loan.
Also referred to as a ‘secured’ loan, a collateral loan is a type of loan that is backed by a valuable asset that you own, such as a house or car. Since your loan is collateralized, the lender can repossess the asset of value if you don’t pay the loan back. As such, a collateral loan is less risky for the lender and is generally easier to get approved for.
As a result of the lower risk that comes with collateral loans, you may be able to qualify for a lower interest rate compared to an unsecured loan. You may even be able to secure a larger loan amount and more favourable loan terms.
In some cases, collateral loans may be the only option available to borrowers who may not have the financial and credit profile needed to get approved for an unsecured loan.
Your lender will assess the value of the asset you’re using to secure the loan. In the case of a mortgage, for instance, the lender will have the home professionally appraised to verify the current market value of the property. The lender will then consider the value of the asset when determining how much of a loan to offer you.
There are several types of loans that require collateral as security, including the following:
A mortgage is a common example of a collateral loan. In this case, the house would be used to collateralize the loan. Your lender will provide you with a lump sum of money to buy the home and will place a lien on the property until the loan is fully repaid.
If you default on the loan, your lender could repossess the home and sell it to get back the funds loaned.
If you own a home and have built up some equity in it, you can use your equity as collateral and borrow against it via a home equity loan. Equity refers to the value of the home, less any outstanding debt.
A home equity loan may be easier to get approved for because of the value of the asset backing the loan. As such, you may be able to get a competitive interest rate on the loan. But like any other loan type, you’ll need to keep up with payments, or you risk losing your home.
A HELOC is similar to a home equity loan because you’re borrowing from your home’s equity. However, a HELOC is a type of revolving credit, like a credit card. You’re free to withdraw as much or as little from your home’s equity as you like, up to an approved credit limit.
You only pay interest on the money withdrawn, until you pay it back. With a HELOC, you can borrow again and again whenever the need for extra cash arises without having to reapply for a loan. But if you fail to repay the money as per your loan contract, you risk losing your collateral.
A car loan provides you with the funds needed to cover the purchase price of a vehicle. With this type of secured loan, the vehicle you’re buying serves as collateral.
Once the loan is approved, you’ll start making repayments right away until the full loan amount and interest are repaid. Payments are made in installments according to an agreed-upon payment schedule.
With auto financing, the lender places a lien on the title of the vehicle. You technically don’t own the car until the loan is paid off in full. Until then, if you default on the loan, your lender reserves the right to take the vehicle back.
If you need to borrow money and own your car outright, a car title loan might be an option. These loans are usually short-term and come with high-interest rates.
With this type of loan, your car title collateralizes the loan. If you default, the lender can repossess your car.
The funds from a personal loan can be used for just about any expense, such as car repairs, home repairs, or consolidating debt. All types of assets can be used as collateral for a personal loan, such as your home, car, stocks, and insurance policies. But if you default on the loan, you risk losing these assets.
To maximize your chances of getting approved for a collateral loan with a low rate and affordable terms, follow these tips:
You should regularly get a copy of your credit report to find out what your credit history looks like and where your credit score is at. You’ll need a good score to get approved for a collateral loan from a bank or credit union at a low rate. Check your credit score before applying for a loan to make sure you know where you stand and to determine whether or not steps should be taken to give your score a boost.
Interest rates and loan terms vary quite a bit from lender to lender, so it’s important to compare loans to see where you can get the best deal. The offers from prospective lenders are based on your financial and credit profile, so getting pre-qualified will ensure that the offers are accurate. Lenders will look at your income credit score and other information you provide to pre-qualify you. Moreover, pre-qualifying does not require any hard credit checks, which can help you avoid any unnecessary credit inquiries.
Once you’ve been pre-qualified, you can compare offers based on the interest rates and loan terms offered. Ensure that your lender accepts the form of collateral you’re offering.
After comparing lenders, you can go ahead and complete your loan application. Lenders need certain documentation to verify your income, assets, and debt. Common documents for loans include bank statements, pay stubs, and tax receipts.
If you’re satisfied with the offer, you can formally apply for a collateral loan. Make sure the application is completed in full and that all information is accurate and up-to-date. In some cases, you may need to submit additional documents if requested by your lender.
If everything checks out, you’ll be notified of your approval and will receive your funds shortly after.
Securing a loan with collateral can give you access to a bigger loan and a lower interest rate. But collateral loans also come with some drawbacks. Let’s take a look at some of the pros and cons of collateral loans.
Collateral loans are available from a variety of sources. Your financial and credit profile may determine which option you can borrow from:
The bank that you already do your basic banking with is a traditional resource for all types of loans, including collateral loans. You’ll need to have good credit and a healthy income to qualify for a secured loan from a bank, as their lending criteria are stringent.
To be eligible for a collateral loan from a credit union, you’ll need to be a member. Otherwise, you’ll first need to become a member before applying for a loan from a credit union. These financial institutions may have somewhat strict lending requirements, but they may not be as tough as banks and may even offer lower interest rates.
Alternative online lenders typically offer unsecured loans, though many offer collateral loans as well. While these lenders usually charge higher interest rates compared to banks, you may be able to get a more affordable rate if you offer collateral.
If you’re buying a car, you may be able to apply for a loan directly from the auto dealership. Working directly with the dealer is a more convenient way to get a loan, which can be arranged at the same time you finalize a car purchase.
Collateral is a great way to get the money you need without having to settle for less. It provides the security that your lender needs so you can get the loan you want. Always consider a secured loan before you give up, more often than not it offers the best solutions for everyone involved.
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Lisa has been working as a personal finance writer for more than a decade, creating unique content that helps to educate Canadian consumers in the realms of real estate, mortgages, investing and financial health. For years, she held her real estate license in Toronto, Ontario before giving it up to pursue writing within this realm and related niches. Lisa is very serious about smart money management and helping others do the same.
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