A guide to loans using collateral

You have many options to choose from when you need to borrow money, and loans using collateral are a popular tool that offer many benefits. Just like with any tool, though, it’s important to understand how it works so you can use it safely, without compromising your physical (and financial) health. 

When used appropriately, secured loans using collateral can help you get the funding you need at a better price point than most other funding methods. They do come with risks, however; chief among them is losing your collateral if you default on the debt. 

Let’s take a closer look at how secured loans work so you can decide if it’s worth using them the next time you need to borrow money.

What are collateral loans, and how do they work?

Loans can be categorized in many ways, but one of the most important is whether they use collateral or not. Secured loans, like mortgages, auto loans, or home equity lines of credit (HELOCs), are attached to something of value that your lender can repossess if you don’t uphold the terms and conditions of the loan contract, such as by paying on time. 

Unsecured loans, like credit cards and student loans, don’t use collateral for the loan. If you default, the lender can’t sell anything to satisfy the debt. Instead, lenders may opt to sue you in court or sell your debt to a debt collector. 

This path isn’t as straightforward a way to recoup their costs, so lenders typically respond by tightening access to credit, offering smaller loans, and increasing interest rates on unsecured loans. That way, lenders lower their risk of losing money. 

Pros and cons of collateral loans

Pros

• Easier qualification: Especially for applicants with low credit scores or adverse credit history, such as bankruptcies.
• Lower interest rates: Save money when more of your payment goes to the loan, not the lender.
• More borrowing options: HELOCs offer flexible funds and HEIs require no monthly payments.
• Lower monthly payments: Smaller interest rates and longer loan terms help shrink your monthly payment.

Cons

• Ties up funds: Borrowing against collateral reduces your equity, meaning you can’t borrow against it again until you repay the debt. 
• Foreclosure potential: A rare, but possible occurrence for failing to repay the loan. 
• Few collateral options: Limited mostly to equity stored in homes, vehicles, or bank accounts.
• Lengthier loan underwriting period: The lender must verify your collateral on the loan application, which takes additional time.

Loans using collateral: Guide to your options

Several types of loans use collateral in different ways. 

Secured personal loans

Although unsecured personal loans are more common, some lenders also offer secured personal loans. 

Banks and credit unions may allow customers to use their existing savings account or a certificate of deposit to qualify, which means you’ll essentially already need to have a large sum of cash on hand in order to get approved. The benefit here is that you’ll still have a healthy savings account remaining after you pay off the loan, as your deposit grows and matures over time. 

Alternatively, some lenders allow you to use a vehicle as the required collateral for a secured personal loan, such as a car or RV. Be careful if you’re using your main transportation source as collateral, especially if losing it would impact your ability to get to work and earn an income.

Pawn loans

Pawn loans are small loans made by pawn shops using household items of value as collateral for the loan, such as jewelry, a guitar, or a computer. Each piece of collateral is assessed on a case-by-case basis for value by the pawnbroker. If they accept the item as a pawn, they’ll disburse the loan funds and hang onto the item in their shop. 

The person pawning the item has a set period of time to repay the loan and reclaim their collateral. If they don’t, then the pawnbroker gets to keep the item and sell it in their shop. 

Auto loan

Auto loans — i.e., loans used specifically to buy a vehicle — are a common type of secured loan. If you don’t repay the loan funds, after all, your lender can repossess your car. 

Lenders sometimes offer large loan amounts on auto financing, but since funds are used only for one specific purpose (i.e., buying the vehicle), they’re not of much practical use if you need to borrow additional funds. The exception is auto equity loans, which — like secured personal loans using your vehicle as collateral — allow you to pull equity out of your car. Auto equity loans aren’t as common, but they do exist. 

Home equity-backed loans

Real estate loans — in all their various flavors — are one of the most common examples of loans using collateral. Mortgages, refinance loans, reverse mortgages, home equity loans, HELOCs, and home equity investments are all considered funding sources that use your real estate property as collateral for the secured loan. 

Real estate is the largest source of wealth for many Americans, which is why lenders offer abundant options for using this equity. In addition, equity-backed loans offer the potential for much larger loan amounts. A home carries more value when it comes to getting a mortgage, after all, than a guitar does when taking out a pawn shop loan. 

401(k) loans

If you have a 401(k) or similar retirement savings account from your employer, you may be able to borrow against a portion of your account while using the remaining funds as collateral for the loan. 

A 401(k) loan offers several unique benefits. There’s no need for a credit check, and the interest you pay goes back into your 401(k), since you’re essentially borrowing your own money. However, the loan will need to be immediately repaid in full if you separate from your employer for any reason, and the interest you pay yourself is typically less than you’d earn if your funds stayed invested in the stock market. 

What to consider before taking out loans using collateral

The biggest consideration when taking out a secured loan is how confident you are that you can make your payments on time for the duration of the loan. That’s especially true if you’re using something as collateral that’s critical for your ability to stay healthy and earn an income, such as your home or your car. 

If you default on a car or home loan, it could set a chain of cascading events into motion that could result in you becoming homeless. It’s an especially important point to guard against, since defaulting also destroys your credit in the process. That makes it less likely you’ll be able to qualify for rental housing or transportation options that may require good credit to qualify.

Frequently asked questions

Can you get a loan using collateral?

Yes, if you have sufficient equity, income, and creditworthiness. Many lenders will allow you to use your home as collateral for a Home Equity Line of Credit (HELOC) or Home Equity Investment (HEI). 

How much can I borrow against collateral?

If you own a paid-off house, you may be able to borrow up to 80% of your home’s value, depending on lender requirements. Homeowners who are still paying off a mortgage may be limited to a smaller amount. 

Are collateral loans risky?

Collateral loans can be risky in the sense that the lender can foreclose on your home if you default, although that’s rare. It’s something to consider with long-term mortgages, home equity loans, and home equity investments (HEIs), however. In contrast, they can also be viewed as less risky because they don’t carry the higher interest rates associated with unsecured debt.

Final thoughts

Loans using collateral are a common tool in today’s financial world, and — used well — they can really help you and your family reach your financial goals sooner. However, it’s important to assess your long-term ability to repay the loan. That’s an important factor with any loan, of course, but especially one where your lender can take ownership of your collateral if you fail to repay the loan.

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