There are two types of loans — one that requires collateral, and the other that does not require any “security”. Today, we are going to put some light on what collateral loans are. We will provide all the essential information to help you understand what this type of loan is all about, and why you should consider getting one.
In an investigative paper entitled, “Secured Lending and Borrowers’ Riskiness” by Alberto Franco Pozzolo, it says that “a large number of bank loans are backed by real or personal guarantees.” Furthermore, it states that according to a report by Berger and Udell (1990), nearly 70 percent of all commercial and industrial loans in the United States are made on a secured basis.
Meanwhile, in a report published online by Statista, it says that from March 2014 to June 2020, the loans granted by various commercial banks in the United States amounted to an estimated 14.85 trillion U.S. dollars. Definitely high as compared to previous years. We thought the numbers might even spike in the coming months given the current situation in the country and all over the world.
Getting loans is inevitable especially during crucial times when our financial capabilities are testes – times such as now.
Now, if you are new to borrowing money from financial institutions or lending company, know that as mentioned, there are two types of loans – secured and unsecured loans.
Secured loans are collateral loans, which means, you can only apply for the loan if you have collateral that serves as the company’s “security” should you fail to meet your obligations. Meanwhile. Unsecured loans allow you to borrow money without the need for collateral.
It is important to understand both. However, today, we are going to focus on understanding what are collateral loans.
For your reference, here are the different points that we are going to tackle:
- What is collateral?
- How does collateral work?
- What are the different types of collateral?
- What is a collateral loan?
- What are the different types of collateral loans?
- How to apply for a collateral loan?
- What are the pros and cons of collateral loans?
WHAT IS COLLATERAL?
Before we even talk about what collateral loan is all about, let us first define what collateral is.
The term collateral, according to Investopedia, refers to an asset that a borrower provides, while the lender accepts to serve as “security” for a loan.
Collateral comes in different forms depending on the type of loan, and also, depending on what the lender requires. It could be in the form of a real estate, vehicle, or other kinds of assets based on the purpose of the loan.
The collateral serves as a form of protection for the lending company in case the borrower defaults on their loan payments. Should that happen, the lender can seize the collateral in lieu of the missed loan payments. The lender will then have to decide whether to sell the asset or keep it.
HOW DOES COLLATERAL WORK?
When borrowing through a secured loan, normally, the borrower will have to go through a certain process wherein the lender will check if you have the ability to repay the money you are loaning for. And one of the factors that they consider, rather, the most important factor that lenders will look into is if you have collateral that will serve as security for the loan.
Generally, collateral helps minimize the risk for lenders. It gives them a sense of assurance that no matter what happens — especially if the borrower defaults — the lender has a sort of “security blanket” in the form of the borrower’s asset.
As mentioned earlier, in case the borrower does default, the lender will automatically have the power over the collateral. The lender could sell it and apply the money it gets to the unpaid portion of the loan. If for instance, the collateral is not enough to cover the remaining balance, the lender has the option to pursue legal action.
Collaterals come in different forms — it could be in the form of real estate, a car, etc. Usually, it relates to the nature of the loan, which we are going to talk about in detail later on.
Generally, secured loans or collateral loans are available in lower interest rates as compared to unsecured loans.
In addition, just so you know, a lender’s claim to a borrower’s asset, which was made collateral is called a lien. It basically refers to the lender’s legal right or claims against an asset to help satisfy a debt, according to Investopedia.
WHAT ARE THE DIFFERENT TYPES OF COLLATERAL?
Now, before we answer the question, “What are collateral loans?” Allow us to provide you first with the different types of collateral available and/or accepted by lenders when aiming to get a secured or collateral loan.
If you are a borrower, it is important that you know the different types of collateral so you get to determine if you can afford a secured loan or not.
As mentioned, any asset can serve as collateral — but that depends on the requirements of the lender. Thus, it is important that you ask your preferred lending company first what they do and do not accept as collateral before you apply for a secured loan.
Generally speaking though, lending companies or financial institutions prefer assets that are easy to value and turn into cash.
One perfect example is money in a savings account. It usually is great for collateral. Why? It is because lenders know how much their value is, and it’s very easy to collect.
Apart from that, here are some other forms of collateral:
- Real estate (including equity of your home)
- Insurance policies
- Cash accounts (except retirement accounts – although there may be exemptions)
- Machinery and equipment
- Valuables and collectibles
- Future payments from customers (receivables)
Please note that even if you are planning to get a business loan, personal assets may also be considered or part of a personal guarantee. Meanwhile, retirement accounts like IRAs are usually not allowed to serve as collateral.
In addition, we thought you might as well know that when it comes to valuing your assets, generally, lenders offer less than the value of the pledged asset. Some assets may even be heavily discounted. The purpose of doing this is that lenders will have more chances of getting all their money back just in case the investment loses value along the way.
As a borrower, it is important to keep in mind that in case your pledged assets lose value for whatever reason, there would be a greater chance that you might have to pledge additional assets to ensure a collateral loan in place.
Ideally, you must pay whatever you owe and keep your asset with you. That should always be the aim of any borrower of a secured loan. Otherwise, it’s much of a hassle really.
WHAT IS A COLLATERAL LOAN?
We always say this — loans are inevitable. All the more these days when times are really tough. Loans allow us to get through certain points in our lives — like emergency situations and money is scarce.
Good thing though lending companies and/or financial institutions do exist. While there is an easier way of getting a loan through unsecured loans, the downside is that it costs a lot.
But there is one more option available though that comes with better rates — secured loans or also known as collateral loans.
Based on the definition of what collateral is, a collateral loan refers to a type of loan wherein the lender requires an asset to serve as collateral. The collateral serves as the lender’s assurance that should the borrower do not meet his or her loan payment obligations, the lender can seize the collateral and sell it to recover some or all of its losses.
As compared to unsecured loans, secured loans or collateral loans do have lower interest rates. Needless to say, the requirements are less strict because collateral exists. Thus, this makes it ideal for people who have assets and are not afraid to lose their assets in case of default.
Before we move on, if you are seriously considering getting a collateral loan anytime soon, we suggest you check the video below by eHowFinance wherein they share about tips on collateral loans.
WHAT ARE THE DIFFERENT TYPES OF COLLATERAL LOANS?
Now that you already know what a collateral loan is all about, this time, we are going to talk about what are collateral loans – its types and a definition of each, of course.
While there are different types of collateral loans, below are some of the most popular examples of collateral loans:
- Personal Loans
- Auto Loans
- Small Business Loans
- Margin Trading
While most personal loans are unsecured loans, there are also a couple of secured ones.
Generally, consumers use personal loans to consolidate existing debt, build credit, or finance everyday expenses.
As mentioned, personal loans come in two different types — secured and unsecured.
Just like any secured loan, personal loans are backed by collateral. By having collateral, it helps reduce the lender’s exposure to the risk of default.
More so, with secured personal loans, lenders are able to charge a lower interest rate as compared to unsecured personal loans.
Apart from a physical property like houses or vehicles, lenders also accept monetary assets such as savings, future paychecks, or investments as collateral for personal loans.
Auto loans are one of the most common types of secured loans used by a lot of consumers.
For this particular collateral loan type, the asset being purchased, or the car that is being purchased is used as collateral for the loan.
It is usual to a lot of lenders mandating that assets be appraised to know the proper value of the collateral. This process helps lenders determine whether it is worth the approval of the loan or not.
Just like auto loans, mortgages are also another very common collateral loan type. Similar car loans, it also uses the asset being purchased as collateral for the loan.
When it comes to appraisal, as compared to auto loans, lenders are more strict in mandating that the property be appraised to determine the current value of the collateral.
The appraisal process is particularly important for mortgage applicants because lenders only approve home loans if the appraised value matches or exceeds the sale price.
Small Business Loans
If you have a growing business, and you need funds to help finance its needs, one of the most popular ways business owners do is to apply for a small business loan. Small business loans can be used for different reasons like financing office space, hiring new people, as well as in purchasing new equipment.
Normally, acceptable collateral for this type of loan includes future payments by customers, inventory, as well as real estate. Personal assets of the business owner/s may also be used to secure approval for this type of loan.
In some cases, there are lenders that require a “personal guarantee” from small business owners. This refers to a written promise or assurance that the borrower’s personal assets can be seized if the company fails to meet its financial obligations to the lender.
Although this one’s not as highly popular as the previous ones, collateralized loans are also considered a factor in margin trading.
What happens is that an investor would borrow funds from a broker to buy shares. The investor will then use the balance in his or her brokerage account as collateral to the loan.
The loan helps increase the number of shares the investor can buy, which multiplies the potential gains in case of an increase in value.
The downside of this type of loan though is that the risks are also multiplied. This means, should the shares decrease in value, it is likely that the broker will demand payment of whatever the difference is, which means the account serves as collateral if the borrower is unable to cover whatever is lost.
HOW TO APPLY FOR A COLLATERAL LOAN?
Now that you already know some of the primary details on collateral loans, this time, we are going to look into the application process.
Generally speaking, the application process for collateral loans vary depending on factors like the type of collateral used, as well as the amount of the loan. Of course, where you apply for a collateral loan will also be factored in as some lenders have a very extensive application process, while others are not.
Just like any other loan application though, borrowers must gather some important documents that lenders need to proceed with the application. This includes documentation such as Social Security number, proof of income, as well as driver’s license and state ID.
Since this is a collateral loan, obviously, borrowers must also be able to provide documentation on the collateral itself like the title or deed for an auto or home loan. If in case the loan is secured by other personal property like bank accounts, insurance policy, or valuables, lenders may require borrowers to provide registration paperwork, photos, or other proof of ownership.
Once all necessary documents are ready, the lender or the financing company will then prepare the loan paperwork. They will also gather signatures from the borrower, and will also do a verification process to ensure the borrower’s eligibility for the loan. The verification includes credit scores, income, identity, as well as the ownership of the collateral.
When all the documentation is already gathered, all paperwork will then be sent through underwriting. Underwriting refers to a process that financing companies use to check on the risk associated with the loan. After this, the lender will make a decision about whether the application gets approved or not. Depending on the company,
Depending on the company, the underwriting process can take either a few minutes or several weeks, especially for mortgage loan applications.
As soon as the loan is approved though, financing companies issue check for the loan amount to the borrower.
WHAT ARE THE PROS AND CONS OF COLLATERAL LOANS?
There’s no such thing as perfect, right? The same philosophy goes to collateral loans, while it does have benefits, it also has its share of downfalls.
Having said that, here are some of the pros and cons we found with collateral loans:
- It offers lower interest rates as compared to unsecured loans. The existence of collateral makes it possible for lenders to provide lower interest rates to borrowers of the loan. Lending companies are assured that even if the borrower does default, they will recover if not all, at least a portion of the loan through the collateral.
- It can help build a borrower’s credit. Lenders report the payments you make to major credit bureaus. Thus, by making payments on time, a collateral loan can definitely help you build your credit score.
- It provides loan opportunities for people with imperfect credit history. Because of the collateral, lenders are more willing to take a risk on borrowers with imperfect credit history. They are assured that no matter what happens, there’s collateral that will serve as the lender’s fallback.
- It provides increased loan amounts. If a borrower does have extensive savings or a certificate of deposit, it would be easier for him or her to borrow larger amounts if need be.
- The application process may take a while. Unlike unsecured loans, collateral loans require a lot of documentation. Needless to say, there’s a verification process as well. Thus, the whole application process may take a while.
- Collateral can be repossessed by the lender due to default. Failure to pay the loan means the borrower will lose the asset, which was made as collateral to the loan. Once it is repossessed by the lender, the borrower automatically loses his or her ownership of the collateral.
FINAL THOUGHTS ON WHAT ARE COLLATERAL LOANS
To sum it all up, collateral loans are ideal for people who own assets that could serve as collateral to the loan. While it does have its risks, the fact that the interest is lower as compared to unsecured loans should make it a valuable choice among borrowers.
Have you thought of getting a collateral loan anytime soon? How do you find it so far?