How to Use Collateral for Personal Loans

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Reviewed byAlvin Yam, CFP
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Reviewed byAlvin Yam, CFP
Edited byCasie McCoskey
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Updated: May 2, 2024

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When faced with unexpected medical bills or the need to consolidate credit card debt, many turn to personal loans as a solution. These provide quick access to funds that borrowers can use for a variety of purposes, ranging from covering emergency expenses to funding large purchases.

Most personal loans are unsecured, meaning they don't require collateral like a car or home. However, in some instances, especially when the borrower has a lower credit score or little to no credit history, collateral may be necessary. While having collateral can offer more favorable terms, you risk losing the asset if you don't repay the loan.

Knowing what you can use as collateral and its implications can empower you to use your assets wisely, aligning with your financial goals and circumstances.

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What Is Collateral?

Collateral plays a pivotal role in securing personal loans. When a borrower offers an asset as collateral, it essentially acts as a backup for the lender. If the borrower cannot repay the loan, the lender has the right to take possession of the collateral and sell it to recover the owed amount.

Typically, having collateral leads to more favorable loan terms, such as lower interest rates or larger loan amounts, especially for borrowers who might not qualify for unsecured loans due to less-than-ideal credit scores or income levels.

Once you offer an asset as collateral, the lender will assess its value. They will also place a lien on the collateral, which is a legal right or claim against the asset until you repay the loan. This ensures that the borrower cannot sell or transfer the ownership of the collateral without the lender's consent. In case of a loan default, the lender can enforce the lien, seize the asset and arrange for its sale to recover the outstanding loan balance.

When Personal Loans Require Collateral

Whether you need to use collateral depends on the type of personal loan you get. An unsecured personal loan generally doesn’t require collateral, whereas a secured personal loan necessitates one.

Unsecured Personal Loans

Unsecured personal loans, as the name suggests, do not require collateral. This means borrowers don't have to pledge any assets, like a car or house, as security for the loan.

The absence of collateral typically makes unsecured loans more accessible to a broader range of borrowers but also influences the loan terms. Since the lender takes on more risk without any assets to fall back on in case of default, these loans often come with higher interest rates than secured loans.

Lenders primarily focus on the borrower's creditworthiness to determine eligibility for an unsecured personal loan. This includes evaluating credit history, credit score, income level, employment stability and debt-to-income ratio. A strong credit history and a high credit score indicate to lenders that the borrower has a track record of managing debt responsibly, making them more likely to repay the loan.

Lenders also consider the borrower's income and employment stability to assess their ability to make regular payments. As a result, unsecured personal loans often require thorough financial scrutiny but provide a viable option for those who either lack collateral or prefer not to risk their assets.

Secured Personal Loans

Secured personal loans require collateral, meaning borrowers must offer an asset as security. If the borrower fails to repay the loan, the lender can seize the asset to recover the loan amount.

The inclusion of collateral generally results in more favorable loan conditions. Borrowers can often access lower interest rates and larger loan amounts than unsecured loans, as the lender's risk is reduced.

The presence of collateral also affects the application process for secured loans. In addition to the standard credit checks and financial assessments, the process involves assessing the value of the collateral. The lender appraises the offered asset to determine its current market value and decides the loan amount based on this valuation. This step ensures that the loan does not exceed the value of the collateral.

Borrowers also need to provide documentation proving ownership and the value of the asset. As such, while secured personal loans can offer better terms, they require the borrower to risk a valuable asset and undergo a more comprehensive application process.

Side-By-Side Comparison
Unsecured Personal Loans
Secured Personal Loans

Collateral Requirement

No collateral required.

Collateral is needed.

Interest Rate

Generally higher due to increased lender risk.

Typically lower as the lender has collateral as security.

Loan Amount

May vary depending on factors like your creditworthiness.

Can be higher depending on the value of the collateral.

Purpose

Can be used for a variety of purposes like debt consolidation, medical expenses or home improvements.

Often used for larger expenses due to the ability to secure larger loan amounts.

Application Process

Focuses on creditworthiness; involves credit checks and evaluation of financial stability.

Involves assessment of creditworthiness plus appraisal and documentation of the collateral.

What Can Act as Collateral

You can typically use real estate or a car as collateral for a personal loan. However, it's helpful to familiarize yourself with other assets you can leverage. Being aware of these options can broaden your possibilities for securing a loan, especially if you don't own a home or vehicle or if you're seeking to use an asset that better matches the loan's size and terms.

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EXPERT TIP

Brokerage firms, including online brokers, typically offer margin loans secured by securities in brokerage accounts. Margin loans are based on the account's current market values, and accounts must maintain minimum balances as values fluctuate. Private banks also offer portfolio loans to high-net-worth clients, typically lending 30%–50% of current securities market values. Interest rates are moderate, and borrowers can usually customize terms.

Both options can provide additional liquidity through loans using stock collateral. However, borrowers take on the risk that declining markets may trigger the sale of their holdings to repay the debt they initially took. — Alvin Yam, CFP®

Pros and Cons of Using Collateral for Personal Loans

Before using collateral for a personal loan, weighing the pros and cons is wise. This decision can significantly impact your financial situation, and understanding the benefits and drawbacks ensures you make an informed choice that aligns with your financial goals and circumstances.

Pros of Using Collateral for Personal Loans
  • Lower Interest Rates: Collateral reduces the lender's risk, often resulting in lower interest rates for the borrower. This can make the loan's overall cost more affordable than unsecured loans.

  • Higher Loan Amounts: With collateral, lenders are generally more willing to offer larger loan amounts, as the asset mitigates the risk. This can be beneficial for borrowers needing substantial funds.

  • Easier Loan Approval: Offering collateral can make getting approved for a loan more straightforward, especially for borrowers with less-than-ideal credit scores. Lenders are more confident when an asset backs the loan.

  • Better Loan Terms: Secured loans can come with more favorable terms, such as extended repayment periods. This flexibility can make managing the loan more manageable for the borrower.

Cons of Using Collateral for Personal Loans
  • Risk of Asset Loss: If you fail to repay the loan, you risk losing the collateralized asset. This can be a significant drawback, especially if the collateral is a home or other high-value asset.

  • Limited by Asset Value: The value of the collateral often limits the loan amount you can access. If your asset has a lower value, this can limit the amount of money you can borrow.

  • Asset Depreciation: Some assets, like vehicles, can depreciate over time. This depreciation can affect the amount of credit available or the terms of the loan.

  • Complex Application Process: Secured personal loans often involve a more complex application process, including asset valuation and additional paperwork. This can be more time-consuming and demanding compared to unsecured loan applications.

EXPERT TIP

In most cases, interest on personal loans isn't tax deductible if you use the funds for personal expenses. However, interest on loans you use for specific purposes may qualify for tax deduction. For example, you may deduct interest on secured loans you're using to finance certain allowable projects, like home improvements. Or, if you meet IRS criteria, self-employed borrowers can deduct loan interest for business needs.

Note that if a lender cancels or forgives a personal loan, the canceled amount may be treated as taxable income by the IRS through its cancellation of debt (COD) rules. — Alvin Yam, CFP®

Alternatives to Using Collateral for Personal Loans

Exploring alternatives to using collateral for personal loans allows you to consider less risky or more suitable options based on your financial situation. These include:

  • Co-Signer: A co-signer is someone who agrees to repay the loan if you can't, reducing the lender's risk. This can help you qualify for a loan or get better terms without collateral. It's ideal if you have a trusted individual with a strong credit history who is willing to take on this responsibility.

  • Home Equity Loan or HELOC: If you own a home, you can borrow against its equity. Home equity loans or home equity lines of credit provide access to large amounts of money but put your home at risk if you fail to repay. They are suitable for homeowners who need substantial funds and are comfortable with the associated risks.

  • 401(k) Loan: Borrowing against your 401(k) retirement fund is an option that doesn't require external credit checks. The risk here is that it can affect your retirement savings if not repaid, plus there may be tax implications. Consider this option if you have substantial 401(k) savings and a stable repayment plan.

  • Peer-to-Peer Lending: These platforms connect borrowers with individual lenders, bypassing traditional financial institutions. The terms and rates vary, and no collateral is usually required. This can be a flexible option for those with moderate credit looking for an alternative to traditional bank loans.

EXPERT TIP

Understand applicable limits and rules when considering a 401(k) loan. The IRS allows borrowing up to 50% of your vested balance, capped at $50,000 or $10,000 if 50% is less than that amount. To avoid penalties, you must repay loans within five years or upon leaving your employer.

The interest on these loans is typically the prime rate plus 1% and paid into your account. Any missed payments have tax consequences similar to in-service distributions: you will owe income taxes on the loan amount plus 10% in penalties if you are under age 59 ½. — Alvin Yam, CFP®

FAQ About Collateral for Personal Loans

It’s common to have concerns about whether you need collateral for your personal loan. MoneyGeek answered some frequently asked questions to help you make informed decisions.

Does a secured personal loan build credit?
Where can I get secured personal loans?
Can I pay off a secured personal loan early?
What is the risk of collateral?
Can land be used as collateral?
Can you change the collateral on a loan?
Can a collateral property still be sold?
Does collateral get returned?
What is insufficient collateral?
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The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.

Editorial Disclosure: Opinions, reviews, analyses and recommendations are the author’s alone and have not been reviewed, endorsed or approved by any bank, lender or other entity. Learn more about our editorial policies and expert editorial team.