Financial institutions offer two main types of loans: secured loans and unsecured loans. The major difference between them is that with secured loans, borrowers have to put up collateral. Collateral is something valuable that acts as a safety net for the lender in case the borrower can't pay back the loan. It reduces the risk for the lender because they can sell the collateral if needed to cover any losses.
What is a Collateral Loan?
A collateral loan is also known as a secured loan. In this type of loan, the borrower has to pledge an asset to get the loan. The amount of the loan approved depends on the value of the collateral. In collateral loans, the lenders are at relatively no risk as they can liquidate the asset to recover their loan amount if the borrower defaults. Since these are unsecured loans, borrowers can get approved for a higher loan amount at a lower interest rate.
How Collateral Loan Works?
The lenders sanction the loan only when they are convinced that the borrower has the financial capacity to repay the loan. To ensure that they are risk-proof, they ask for some form of security. This security is known as collateral, and it;
- minimises the risk for lenders
- ensures that the borrower keeps up with their financial obligation
- ensures that a lender receives full or partial compensation for any outstanding balance if the borrower defaults on the loan.
Examples of Common Assets Used as Collateral
- Commercial and residential property
- Private vehicles
- Machinery and equipment
- Insurance policies
- Investments such as FDs, mutual funds, bonds, shares, ESOPs
- Valuables and collectibles
What Types of Loans Require Collateral?
Here are a few common examples of collateral loans:
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Home Loan
In this type of secured loan, the home purchased acts as collateral for a home loan. If you default, you risk losing your house.
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Auto Loans
In this type of collateral loan, the vehicle you buy is the collateral. In case of a default, most lenders prefer to work with the borrower to ease their repayment terms rather than seizing the car because cars are depreciating assets.
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Small Business Loans
In small business loans, future payments by customers, real estate, and inventory are used as collateral. Borrowers can also put up their assets as collateral to get a small business loan.
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Personal Loans
Unsecured personal loans are generally used to consolidate existing debt, cover personal expenses, or build credit. Secured personal loans have a lower rate of interest than their unsecured counterparts.
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Loan Against Property
An existing home acts as collateral for this type of collateral loan. The loan is usually taken for home improvement projects but can be used for any purpose.
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Loan Against Securities
In this type of loan, financial assets like shares, bonds, etc., are pledged as collateral. The borrower can take short-term loans of up to the value of the assets.
How to Apply for a Collateral Loan?
Steps to Apply for a Collateral Loan:
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Check Your Credit Score: Start by checking your credit score before applying for a collateral loan. A higher credit score makes it easier to qualify for a loan.
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Compare Secured Loan Options: Look into secured loan options from different lenders after getting prequalification. Compare factors like interest rates and fees to find the best deal. For example, you can explore loan options from Freo (Formerly MoneyTap).
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Gather Required Documents: Make sure you have all the necessary documents requested by the lender ready before filling out the loan application.
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Submit Your Application: Complete the formal loan application, providing accurate information about your collateral and other details as requested by the lender.
Frequently Asked Questions
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Why do financial institutions ask for collateral?
Financial institutions request collateral to make loans more secure. Even borrowers with good credit scores may sometimes fail to repay their loans. Collateral helps protect the interests of lenders by giving them the option to sell the asset if the borrower doesn't repay the loan.
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What are the risks of collateral loans?
The main risk with collateral loans is that if the borrower can't repay the loan, they could lose the asset they put up as collateral. If this happens, the lender can take and sell the collateral to recover the loan amount.
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Are collateral loans suitable for everyone?
Collateral loans might work for people who have valuable assets to use as collateral and can manage loan repayments responsibly. However, it's important to think about your financial situation and understand the risks and benefits before going for a collateral loan.
