What is the danger of putting up collateral for a loan?

Many types of loans require pledging collateral, like your home or car, in exchange for financing. These are called secured loans, which can include mortgage loans, home equity loans, HELOCs, car loans, and secured personal loans. As with any type of financing, secured loans have their pros and cons.

What is a loan collateral, exactly? What collateral can be used for a loan? And what is the danger of putting up collateral for a loan? This helpful article will answer these and other important questions so you can make a more informed decision on a secured loan.

What is a collateral loan?

What, exactly, is a collateral loan, and what does collateral mean for a loan, you wonder? A collateral loan is a secured loan where you pledge some asset of value as a guarantee and form of security.

“Think of it like this: You are telling the bank, ‘If I can’t pay this back, you can take this valuable thing instead,’” explains personal finance expert Andrew Lokenauth.

If you default on the loan, which means you fail to repay on time or according to the loan’s terms, the lender can seize the collateral to recoup its losses. The worth of your pledged asset will be assessed to determine how much can be borrowed against that asset.

What can be used as collateral?

The asset you can use as collateral will depend on the type of loan and what the lender requires.

“Eligible loan property collateral includes residential and commercial real estate property, automobiles, industrial equipment, inventory, accounts receivable, publicly traded stocks and bonds, precious metals, fine art, jewelry, patents and trademarks, and even domain names or wallets for cryptocurrency and particularly niche markets,” notes City University of New York Professor of economics and finance Dennis Shirshikov.

Homes and cars are the most common types of collateral used for mortgage/home equity loans and auto loans, respectively.

“Ultimately, you can use anything as collateral so long as the lender will accept it,” says Martin Orefice, CEO of Rent To Own Labs.

However, banks and lenders typically prefer collateral that’s easy to value and sell. That’s why property like real estate, which is easier to value and liquidate, is preferred over things like art collections and rare items.

How do collateral loans work?

Okay, but you may still be wondering: How does collateral work on a loan? As stated above, a collateral home loan requires a pledged asset, the value of which will need to be verified. The lender will request a formal valuation or appraisal to establish the market value of this asset.

Next, the lender will determine a loan-to-value (LTV) ratio to figure out how much you’re allowed to borrow. After that, they’ll secure their interest in the asset, usually by placing a lien on it or holding onto important documents like certificates. A lien is a legal claim the lender retains on the asset, giving them the right to claim the asset if you don’t repay your debt.

With a mortgage loan, home equity loan, or home equity line of credit (HELOC), for instance, the market value of your home – which you will use as collateral – has to be carefully determined so that the lender can know how much they are willing to lend you.

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Benefits of collateral loans

Secured loans offer several benefits. Here’s a breakdown of each:

You may pay a lower interest rate

The interest rate you pay for a secured loan will almost always be lower than the rate charged for an unsecured loan. That’s because offering a collateral loan is less risky for lenders. It’s not uncommon for collateral loan rates to be at least 20% lower than what secured loans charge.

“Your rate could be 3 to 5 percentage points lower in many cases,” says Lokenauth. Hypothetical case in point: Instead of an interest rate of 13.0% for unsecured financing, your secured loan rate could be 8.0%.

You may be able to borrow more

Because you are putting up collateral, the lender will likely be more willing to increase your borrowing limit, especially if the value of that collateral is significant. A higher borrowing ceiling could mean the difference between, for instance, purchasing a bigger and more lavish home versus a smaller, less well-appointed property.

It’s often easier to get approved

It’s usually easier to get the green light on a secured loan over an unsecured loan, even if you have a lower credit score or limited credit history. The reason? The lender incurs lower risk because, if you don’t repay your debt, they can seize your collateral. Unsecured loans need to work carefully vet your earnings, credit score, and debt history, which can make it harder for the lender to say yes.

More flexible terms

Collateral loans commonly offer longer repayment periods than secured loans, allowing you to stretch out your repayment schedule and lower your monthly payments if you choose a longer term.

Risks of collateral loans

Then again, collateral loans come with risks and drawbacks. Let’s explore the major ones.

You can lose your collateral

The most immediate danger you face as a borrower is the loss of your pledged asset if you default on your loan.

“If you lose your house, this could be catastrophically disruptive, and you could even be on the hook for deficiency judgments if the sale of the house by the lender doesn’t completely satisfy your owed debt,” adds Shirshikov. “Keep in mind, too, that collateral loans will require more elaborate paperwork and inclusion of more complex legalese, such as cross-collateral clauses or security agreements – which can bind you into certain covenants or trigger an acceleration in the repayment.”

You can be underwater on your loan

There’s also the risk of your collateral losing value. This can happen due to things like market fluctuations, loss, or damage, which can cause you to be underwater on your collateral loan.

“In this case, your lender may recall your loan, require you to refinance it, or force you to put up more collateral,” says Orefice.

Lokenauth recalls how one of his clients used his stock portfolio as collateral right before a market downturn.

“After that, we had to make some tough calls with the lender about additional collateral requirements,” he continues.

It can affect your credit

Falling behind or defaulting on a collateral loan can significantly lower your credit score, often by 50 to 200 points or more. You may also be sent to a collections agency. Additionally, it could become harder to get approved for future loans or credit. The specific consequences will depend on the lateness of your payments on your credit history.

It can complicate the application and approval process

Picking a secured loan over an unsecured loan can result in a more complex and lengthier application and underwriting process. That’s because the lender will need to determine the value of your pledged asset, confirm ownership, and complete legal requirements like placing a lien on the property. These extra steps typically aren’t needed for unsecured loans.

Common types of collateral loans

Secured loans come in several different flavors. Common options include the following.

Mortgage purchase or refinance loans

Conventional mortgage loans usually follow the guidelines set by Fannie Mae or Freddie Mac, which makes them “conforming” loans. Nonconforming loans, such as jumbo loans, exceed federal limits. Fixed-rate mortgages are the most common, offering steady interest rates and predictable payments over 15 or 30 years. Shorter terms mean higher monthly payments but less total interest, while longer terms lower monthly costs but increase interest paid. Adjustable-rate mortgages (ARMs) start with a fixed rate that later adjusts with the market, which can be beneficial if you plan to move soon but carries the risk of rising payments.

Government-backed loans – like FHA, VA, and USDA loans – help borrowers with lower credit or savings by offering low or no down payment options, but often include extra fees or insurance requirements.

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Home equity loans

A home equity loan allows you to borrow a particular amount of money using the equity you’ve accrued as the collateral. You receive the full loan amount upfront in a single payment and then repay it over a set period – usually 15, 20, or 30 years – with a fixed interest rate. This type of loan is ideal for funding big, one-time expenses or projects that need a lump sum of cash.

HELOCs

In contrast, a HELOC works like a credit card but, like a home equity loan, uses your home’s equity as collateral. You can borrow money up to a certain limit whenever you need it during the draw period. The interest rate varies over time, and you only pay interest on the funds you actually use. This makes HELOCs a flexible choice for expenses that come up gradually or over time.

Auto loans

An auto loan is a form of financing that lends money to purchase a new or used vehicle, with that car serving as collateral. You pay back what you borrow in monthly installments over a set term, typically with interest. Instead of paying the full price upfront, these loans permit you to spread out the cost of an automobile, making monthly payments more affordable.

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Collateral loan alternatives

Pledging an asset and pursuing a secured loan isn’t your only choice if you need extra funds. Instead, explore these alternative financing choices:

— Unsecured personal loan. This loan gives you a fixed amount of funds upfront that you repay in regular monthly payments with interest, without requiring any pledged assets.  “These loans don’t pose the threat of repossession of your collateral, although interest rates are higher in credit standards are more stringent to qualify,” cautions Shirshikov.

— Cosigned loan. This loan permits you to use another person’s credit as collateral. In other words, someone else, referred to as the “cosigner,” agrees to be responsible for the debt if you, the primary borrower, do not repay the loan.

— Borrowing from a credit union. Consider borrowing money from a local trusted credit union (a member-owned financial cooperative), which offers more flexible terms and lower interest rates than other lenders and banks. Credit union loans are often unsecured.

— Peer-to-peer lending. This enables you to borrow cash directly from other individuals via an online platform, versus using a bank. It requires no collateral but often charges higher interest rates.

Are collateral loans worth it?

Secured loans can be a good option if you want to pay a lower interest rate, need a higher borrowing limit, desire more flexible repayment terms, and want to up your chances of qualifying and getting approved. But you need to carefully consider the risk of losing your pledged property before going this route.

“If the market value of your collateral is relatively stable, and you can replace or insure your pledged assets, the advantages of collateral loans frequently outweigh the disadvantages. However, in volatile or thinly traded markets, an unsecured loan or a hybrid approach could be the better choice,” says Shirshikov. “My rule of thumb would be to match the term of the loan to both the asset’s liquidity profile and your own tolerance for collateral risk.”

Lokenauth agrees, with a caveat.

“If you are confident in your ability to repay your debt and you can secure a significantly lower interest rate, these loans are worth it. I’ve seen collateral loans significantly help borrowers consolidate high-interest debt, fund home improvements, and start successful businesses,” he adds. “But they are not for everyone. If there’s any doubt about your ability to repay, don’t risk your assets.”

Conclusion

A collateral loan is often preferred by many borrowers because they typically come with cheaper rates, higher borrowing limits, easier approval, and more preferred repayment terms. There are also several types to choose from, including mortgage purchase loans, mortgage refinance loans, HELOCs, auto loans, and home equity loans.

But the loan property collateral requirement is a risk you’ll need to consider carefully. Remember: If you fail to repay the loan as agreed, the lender can claim your pledged property to recover their money. That’s why you should carefully weigh the pros and cons and do the math before committing to a collateral loan.

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