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What’s a Collateral Loan and Why Do I Need One?

Loans have the power to get you ahead in life — or behind. It all comes down to the types of loans and financial agreements you take advantage of. But not all loans are made the same.

No matter your credit score, collateral loans come with some of the best rates around. At the same time, they’re arguably more dangerous than traditional loans. Knowing the ins-and-outs of these arrangements could be the difference between financial success or failure.

But what’s a collateral loan, anyway? And how does it work? Let’s dive deep to answer these questions and more.

What’s a Collateral Loan?

A collateral loan relies on — you guessed it — collateral. Lenders want to know that they can get their money back. To ease their fears, borrowers may offer some of their possessions as collateral.

This is to say that if the borrower defaults on the loan, the banking institution has the legal right to sell the collateral to recoup its losses.

Collateral loans come in many different shapes and forms. It may be a car, a home, or a liquid security deposit.

For example, a mortgage and auto loan are both based on collateral. By failing to repay the loans, the lender will take ownership of the property in question. This is known as foreclosure in the case of real estate.

Almost everyone takes advantage of collateral loans throughout their lifetime. Right now, about one-third of Americans have auto loans — and many more have paid theirs off already.

Collateral loans are sometimes referred to as secured loans.

Why Do I Need a Collateral Loan?

The threat of losing your property is a serious deterrent. So why would you get a collateral loan over an unsecured one? Well, there are just as many advantages as disadvantages.

If you need a loan, here are some reasons why you should offer collateral.

1. Easy to Obtain

Loans aren’t guaranteed. If you have a low credit score resulting from missed payments and other financial mishaps, lenders will be hesitant to work with you. After all, there’s a good chance they may not get their money back.

And in that case, they won’t offer a loan at all. Unfortunately, it’s difficult to live without access to loans. How else will you buy a car or home?

Your best option is a collateral loan. When you put collateral on the table upfront, you can assuage some of these fears. That’s why it’s easier to get your hands on secured loans even if you have a terrible credit score.

2. Build Credit

If you’re young or have bad credit, your borrowing options are limited. How do you increase your credit score and get access to the good stuff?

Well, since collateral loans are easier to get, they should be your first step. Once you’ve opened the account, such as a secured credit card, make sure you pay on time every month.

A positive payment history will improve your credit score from year to year and inform lenders that you’re a safe client.

3. Better Rates

Collateral loan rates are almost always lower than those for unsecured loans. As always, it’s a factor of risk.

Once you’ve pledged collateral, lenders know they’ll get their money back no matter what. For that reason, they can offer better interest rates to sweeten the deal. After all, they’re guaranteed to make a profit on the loan, so they want you to choose their banking institution rather than a competitor.

Better interest rates apply to everyone, not just those with bad credit. A borrower with an 800 credit score or higher will still enjoy a lower interest rate by pledging collateral. Lower interest rates mean you’ll pay less overall.

4. More Credit

In some cases, adding collateral offers more than better rates. You could also qualify to take out a larger loan than normal.

For those who are trying to build credit, this results in a bigger credit line. That makes it easier to stay at a low credit utilization rate, which will give your credit score a nice boost.

But for those taking out mortgage or auto loans, more money unlocks more options. You could have cash left over for a home renovation. And in the case of cars, getting a secured loan over an unsecured loan could bring a more expensive model within your reach.

Risks of Collateral Loans

Amid all the benefits of using collateral, there are a few drawbacks worth considering. The first is the fact that you need collateral to take out collateral loans. That’s not always an option.

The cheapest form of a collateral loan comes with a secured credit card. This may only require a few hundred dollars. But if you want a home equity loan, that means you need home equity before you can use it as collateral.

Not to mention, borrowers assume extra risk with collateral loans. By missing a payment or two, you could end up losing your home, house, or whatever possession it is you’ve put on the table. This is a sticking point even for those with good credit histories.

Sure, you can pay off the loan at the moment. But what about an unexpected layoff or economic downturn? When financial troubles happen outside of your control, your collateral is at risk.

Improve Your Financial Prospects

What’s a collateral loan if not the most affordable way to get what you want, when you need it? On paper, collateral loans may seem scary, but in reality, almost everyone uses them without issue. So long as you maintain a financial safety net, you can make comfortable monthly payments without putting your collateral at risk.

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