What is collateral on a loan — and when do you need it? (2024)

Collateral is a valuable asset (like a car, house or even cash) you can pledge to secure a loan. If you fail to repay your loan, the lender can seize whatever you've put up as collateral. Financial institutions and other lenders usually consider loans secured with collateral less risky, and certain types of loans (such as mortgages) require collateral by default. Sometimes, you can offer collateral as an option to get a loan or a credit product you otherwise wouldn't be able to qualify for.

Below, CNBC Select explains how loans with collateral work, what you can typically use as collateral — and what you want to consider before doing so.

Collateral on a loan backs up your promise to repay the lender with a physical asset. Even if you default on your loan or credit card, the lender can recoup the loss by seizing the asset. This type of loan is also known as a secured loan — the collateral "secures" financing.

For example, if you take out a car loan, your new car becomes collateral and secures the loan. If you stop making payments on your loan, the lender can repossess the car.

Generally, the value of the collateral is sufficient to cover the lender's loss in case of loan default. When that's not the case, the lender may sue the borrower to collect the remaining balance. On the other hand, if you pay off the loan, the lender will remove their claim on your asset, meaning you'll now own that asset free and clear.

What kind of collateral you can use typically depends on the type of loan that needs securing. Here are the most common examples of assets lenders use as collateral:

• Vehicles: When you buy a car or other type of vehicle, that vehicle also secures your loan. Alternatively, you can use your car equity to get a title loan — but make sure you're aware of the risks first.
• Real estate: If you get a mortgage, the home you're buying will be the collateral. And if you've already bought a home, you can use your equity to secure a home equity loan or home equity line of credit (HELOC).
• Cash: In some cases, you can also use a deposit account as collateral, such as a savings account, money market account orcertificate of deposit(CD).
• Investments: Investment accounts can serve as collateral as well, namely for a securities-based loan. This can be an installment loan or revolving line of credit with amounts ranging from 50% to 95% of what you have in your brokerage account.
• Valuables: Finally, valuable property or collectibles like jewelry, antiques and art can be collateral. When securing a loan using these types of objects, the lender will likely require that you submit a collateral appraisal to confirm their value.

Secured loans are a common practice. Several types of loans are designed to use collateral, making it a requirement. These include

• Mortgages: A mortgage is perhaps the first type of secured loan that comes to mind. When you're taking out a mortgage to finance a home, the home becomes collateral. If you fail to make mortgage payments, you may lose your home to foreclosure, losing all the equity you've built.
• Auto loans: Following the same logic, the vehicle you're financing serves as collateral for your auto loan.
• HELOCs and home equity loans: The equity you have in your home can be collateral if you borrow against it. Note that you generally need at least 15% to 20% equity in your home to qualify for this type of financing.

When it comes to financing where the collateral is optional, some of the most common examples include

• Secured credit cards: Most credit cards are unsecured, but they also often require at least good credit (or a credit score of at least 670). Secured credit cards, on the other hand, are an excellent option for those with less-than-perfect credit. A secured credit card uses a cash deposit as collateral, and that deposit usually determines the credit limit of the card. Often the credit limit and the deposit amount are the same, but with the Capital One Platinum Secured Credit Card, you have a credit limit of $200 even if you qualify for the minimum deposit as low as $49 or $99 deposit amount.

• Secured personal loans: Usually, you don't need collateral for a personal loan. But some lenders will allow you to put up an asset as collateral if you have poor credit and otherwise wouldn't qualify for the loan (or qualify with terms you'd find unacceptable). Some examples of lenders that offer secured personal loans include OneMain Financial and Navy Federal Credit Union.

Like most kinds of financing, secured loans can be a useful tool — but they also come with potential disadvantages.

Advantages of secured loans

Besides the fact that using collateral offers you access to financing a home or vehicle, secured loans can provide a few other benefits.

For one, a secured loan or credit card can be an excellent choice for borrowers with limited or poor credit. Collateral can help improve approval odds, as well as offer a way to build credit with on-time payments.

Further, even if you already have stellar credit, opting for a secured personal loan may allow you to access larger loan amounts and get a lower interest rate.

Disadvantages of secured loans

At the same time, secured loans come with certain risks. Defaulting on such a loan can lead to losing the collateral. That doesn't mean you should avoid secured loans altogether. After all, collateral is a requirement for loans like a mortgage or auto loan — and most people don't have the option to buy a house or car without financing. But when you're considering a secured loan, it's imperative to understand the risk before you apply.

Additionally, a secured loan may involve a more complicated application process. For example, if you're using valuables like art or jewelry as collateral, the lender will normally request an appraisal.

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Collateral loans allow you to finance some of life's most expensive purchases, such as a vehicle or a house. They can also help borrowers with poor credit qualify for a credit card or personal loan. Still, as with any financing, it's crucial you understand the potential risks of secured loans — specifically, losing the collateral if you miss enough payments to default on the loan.

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