There are a lot of reasons someone might need an injection of cash and seek out a loan from a bank: For emergencies, home repairs, to pay off credit card debt with a lower interest rate loan.
One consideration when taking out a personal loan is whether it is secured or unsecured. A secured loan is backed by an asset, called collateral, such as a home or car. An unsecured loan, on the other hand, is not collateralized, which means that no underlying asset is necessary to qualify for financing.
Whether to pursue a secured or unsecured loan will depend on a number of factors, such as your credit score, whether you have collateral, the type of financing you need, and when you need it. These personal loan requirements will be covered in full below, as well as discussing what can be used for a personal loan with collateral and financing options that don’t require collateral.
Of course, not all loans are created equal. If you’re planning to take out a loan, it’s important to do your research and find a loan that best fits your needs and financial situation. Learn more about when someone may borrow a personal loan with collateral.
Why Secured Loans Require Collateral
If collateral is used, a lender may be able to offer larger loans, more favorable interest rates, and better terms. That’s because the lender can take possession of the collateral if the loan isn’t repaid as agreed. This is not the case with an unsecured loan.
Because of the lack of collateral, unsecured loans are often limited to borrowers who are viewed as trustworthy. For example, higher credit scores are usually necessary for an unsecured loan.
Unsecured loans usually have higher interest rates, although this is changing somewhat as online-only lenders such as SoFi aim to offer competitive rates for unsecured personal loans. Unsecured loans can be easier to qualify for, simply because there are fewer hoops to jump through.
Digging up all the paperwork for the asset you’ll use as collateral can take quite a while, and then a bank needs to verify it all. When you’re not tying your loan to collateral, the approval process may be a bit smoother.
Fixed Rate vs Variable Rate Loans
Before diving into the details of collateral, it’s helpful to understand some additional loan terminology. One important distinction is whether a loan has a fixed or a variable interest rate. A fixed rate is just as it sounds; The personal loan interest rate stays fixed throughout the duration of the loan’s payback period, which means that each payment will be the same.
A variable-rate loan, on the other hand, is pegged to a floating rate that is typically associated with a benchmark such as the Fed or LIBOR. Usually, variable rates start lower than fixed rates because they come with the long-term risk that rates could increase over time.
Installment Loans vs Revolving Credit
An installment loan is issued for a specific amount to be repaid in equal periodic installments over the duration of the loan. These are generally good for borrowers who need a one-time disbursement.
For example, borrowers looking for a credit card consolidation loan or a mortgage to buy a home will need an installment loan. An installment loan can be both secured and unsecured. With a mortgage, typically the loan uses your house as collateral.
With a line of credit (also called revolving credit), a borrower can spend up to a designated amount on an as-needed basis. For example, if you have a $10,000 line of credit, you can spend up to that limit using what is similar to a credit card.
Related: How to Pay Tax on Personal Loans
Lines of credit are generally recommended for recurring expenses, such as medical bills or home improvements, and also come in secured and unsecured varieties. If you took out a home equity line of credit, it would often be secured (again, using your house as collateral).
What Can Be Used as Collateral on Personal Loans?
Lenders may accept a variety of assets as collateral on a personal loan. Some examples include:
House or other real estate
For many people, their largest source of equity is the home they live in. Even if you don’t own your home outright, it is possible to use your partial equity to obtain a collateralized loan.
If you use a home as collateral on a personal loan, the lender can seize the home if the loan is not repaid. Furthermore, it might take a while to get approved for the personal loan, because the bank has to verify your asset, which means you have to supply plenty of home-related paperwork.
Bank or investment accounts
In some instances, obtain a personal loan with collateral by using investment accounts, CDs, or cash accounts as collateral. Every lender will have different collateral requirements for their loans. Using your personal bank account as collateral can be risky, because it ties the money you use every day directly to your loan.
A vehicle is typically used as collateral for an auto title loan, though some lenders may consider using it as backing for other types of secured personal loans. A loan backed by a vehicle may be a better option than opting for other short-term loans, such as payday loans, but you run the risk of losing your vehicle if you can’t make your monthly loan payments.
Pros and Cons of Using Collateral on a Personal Loans
Using collateral to secure a personal loan can have pros and cons. While it can make it easier to gain approval from the lender, it’s important to review the loan terms in full before making a borrowing decision. Here are some more pros and cons of using collateral to back a personal loan.
Pros of Using Collateral
• Using collateral can improve a borrower’s chances of being approved for a personal loan.
• Borrowers may be able get approved for a larger sum, thanks to the collateral mitigating some of the lender’s risk.
• Borrowers may be able to secure a lower interest rate with a secured loan than they would with an unsecured loan.
Cons of Using Collateral
• If the borrower defaults on the loan, the asset being used as collateral could be seized by the lender.
• In some situations, the lender could go even further to try and get the money owed by the borrower, sending the debt to a collection agency. As with any loan, missing payments could impact the borrower’s credit score.
• Some lenders may have restrictions for how borrowers can use the money from a secured personal loan.
Qualifying for a Personal Loan
With a secured loan, a lender will likely require proof that you own the asset you are using as collateral. This is a simpler process if you are using bank accounts as backing for your loan, because bank statements are easier to obtain and verify.
When you use your home as collateral, it’s usually a more involved process because they require additional paperwork and an updated appraisal to determine the equity value of your home.
If you need a loan quickly, or don’t own a home or car (or don’t want to put either up as collateral), there are still options. Acquiring an unsecured personal loan can be a fast and simple process compared to obtaining a secured loan, and you aren’t putting your home or car at risk.
With both secured and unsecured loans, you will have to provide the lender with information on your financial standing, including your income, bank statements, and credit score. With most loans, the better your financial standing, the better the rates and terms you’ll qualify for.
If you’re considering taking out a loan—any kind of loan—in the near future, it can be helpful to work on improving your credit score while making sure that your credit history is free from any errors.
Shop around for loans, checking out the offerings at multiple banks, credit unions, and online lenders. Each lender will offer different loan products that have different requirements and terms.
With each prospective loan and lender, make sure you understand all of the terms; This includes (but is not limited to) the interest rate, whether the rate is fixed or variable, and all additional fees (sometimes called “points”).
Ask if there are any prepayment fees that would prevent you from paying back your loan faster than on the established timeline.
The loan that’s right for you will depend on how quickly you need the loan, what it’s for, and your desired payback terms. If you opt for an unsecured loan, it might allow you to expedite this process—and you have the added benefit of not putting your personal assets on the line.
Using collateral to secure a personal loan can help borrowers qualify for a lower interest rate, a larger sum of money, or a longer borrowing term. However, if there are any issues with repayment, the asset used as collateral can be seized by the lender.
The right choice will vary depending on the borrower’s financial situation, including factors like the borrower’s credit score and history, how much they are interested in borrowing, and what item they have available to be used as collateral.
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