Collateral for a loan is where you agree to put forward an asset that you own as security when you borrow money. This asset is usually your property or maybe your car, but when collateral is involved in this way, you’re getting what is known as a secured loan.
Here we look in greater depth at the types of loan collateral that can be used and what you may want to consider before going ahead with a loan that requires you to use collateral.
How collateral works for a loan
Using collateral as security against a loan reduces the financial risk to the lender. That’s because if you don’t repay your loan, it has the option to recover the asset or property to pay off the balance.
This safety net for the lender means you might find it easier to get a collateral loan than an unsecured loan where you don’t need security, particularly if you have bad credit. Interest rates might be lower too with a secured loan when compared with an unsecured loan. Of course, the risk to you is that you could lose the asset if you default on the loan.
Types of collateral you can use for a loan
The main types of collateral that you can generally use as security for a loan include:
When you take out a mortgage, your home is the collateral for the mortgage loan and, potentially, for any additional mortgage borrowing, such as:
- A further advance, where you borrow more on your existing mortgage from your current lender, usually at a different rate from your main mortgage. This might be to fund home improvements or raise funds to buy a second property. Your home remains the collateral.
- Homeowner loans, where you take out a separate loan that’s secured against some of the house equity you already hold in a property. These are sometimes called second charge mortgages, because two mortgages are secured against one property. The additional mortgage is usually with a different lender. The amount you borrow can’t be more than the amount of equity you own in the property. Both lenders would want to recoup their losses if you default on payments, but the first lender would have priority on the proceeds of any sale.
Securing additional loans on your home is a big decision and may involve fees and higher interest rates than your existing mortgage loan. You usually need to use a mortgage broker to get a second charge mortgage.
» MORE: Should you take out a loan against property?
Some vehicle finance agreements that aren’t personal loans, such as hire purchase and personal contract purchase (PCP), use the vehicle you’re financing as security.
This isn’t the same as a logbook loan, which is where you secure additional finance on a car you already own and can be a very expensive form of borrowing.
Other options can include:
- Jewellery, art and antiques: It’s possible to borrow against high-value or collectors’ items, including luxury assets such as wine or art collections. These are valued and assessed by the lender and you hand them over (but remain the owner) until the short-term loan has been paid off.
- Investments: Some loans let you borrow against investments such as a shares portfolio. As the value of shares can go down as well as up, this comes with specific risks, such as interest rates on the loan being more than you gain on the investment. The eligibility and availability of these types of loans may be limited to high net worth individuals with a significant investment portfolio.
The type of collateral you can use will depend on its value, the type of loan you are applying for and the lender. The asset’s value usually needs to be more than the loan amount and helps decide the amount of money you could borrow, along with other factors such as your credit history and individual financial situation.
Whatever the asset, the risk is that if you default on the loan you could lose it.
Why choose a collateral loan?
Some loans don’t ask for collateral, so why might you choose one that does?
Pros of collateral loans
Some potential positives of a secured or collateral loan might be:
- Lower interest rates: Secured loans may offer lower interest rates than unsecured loans.
- Larger loan amounts, for longer: You may be offered higher loan amounts that you can choose to take longer to pay off. Although the longer you take to pay a loan off, the longer you’ll be paying interest on the loan, which means it could cost more over the full length of the loan.
- Higher chance of acceptance: If you don’t have a good credit history or any credit history, or have other loans, it may increase your chances of being accepted for the loan.
Cons of collateral loans
There is the risk that you could lose the asset, which may even be the home you live in, if you default on the loan. So you must be confident that repayments would be affordable throughout the loan term.
Secured loans may also include other disadvantages:
- A lengthiery application and approval process, when compared with unsecured loans.
- Arrangement fees for setting up the loan or an early repayment chargeif you pay off the loan early. Check the annual percentage rate of charge (APRC) when you compare loans, as this factors in likely fees and charges and makes it easier to weigh up your options.
- Variable interest rates, where payments could go up. Be clear if the repayments are fixed or variable before going ahead.
» MORE: How secured loans work
What happens if you default on a collateral loan?
If you miss loan repayments, the lender may contact you to ask you to pay what’s owed before the default happens. Contact the lender as soon as you realise you can’t make payments to see if you can agree on a way forward.
Defaulting on payment can affect your credit score and stay on your credit file for six years. This can make it harder to borrow money, as future lenders will see this when they run a credit check.
If you are in arrears, the lender may go on to repossess your home or take the asset and sell it to recoup costs.
» MORE: What to do if you get a default notice
Collateral loans alternatives
Taking out a secured loan needs a lot of thought. Explore other options before going ahead, which might include:
- Unsecured loans, which can be taken out without collateral, meaning your asset isn’t immediately at risk if you fail to make repayments. Always take the time to compare unsecured loans, as interest rates are likely to be higher than on loans where you provide security.
- A guarantor loan, where a friend or relative is effectively your collateral for the loan, as they must promise to pay the loan back if you don’t.
- A credit card, in particular a 0% purchase credit card if you need to borrow for the short-term and you’re in a position to pay it off in full before interest is charged.
Whatever type of borrowing you decide on, comparing loans across providers can help you find the most competitive rates. A broker can also help you decide on the right loan and explain your options.
WARNING: Think carefully before securing other debts against your home. Your home may be repossessed if you don’t keep up repayments on a loan or any other debt secured on it.
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