Chances are, you already understand what a collateral loan is. Otherwise known as a secured loan, these lending products reduce lender risk by pledging an asset they can collect for missing payments. As a result, securing your loan is the secret to a low interest rate.
The most common type of secured loan is a mortgage. For example, your mortgage is collateralized by your home, and the lender has a lien on your title. Missing mortgage payments result in the lender either possessing your home through a foreclosure procedure or selling it through a power of sale process.
In reality, there are many types of secured loans with collateral ranging from cars to jewelry or artwork. However, the asset you are collateralising will affect the features of your loan. For example, to get the best interest rate, you’ll need either a fungible asset (like government bonds) or an immovable asset (like real estate) that’s easy to sell and won’t sharply drop in value.
You can collateralize many types of assets with a secured loan. Continue reading to learn everything about collateral loans and the options you have.
|Type of Secured Loan
|Typical Loan Size
|Credit Score Requirements
|Determined by Lender or Insurer
|Determined by Lender
|1 month - 7 years
|Depending on type of loan
|No minimum requirement
|No minimum requirement
|Secured Credit Card
|No minimum requirement
The difference between secured and unsecured loans is that your lender has no collateral with an unsecured loan. As a result, there is more lender risk with an unsecured loan if you default on your debt payments. Unsecured loans have higher interest rates to compensate for the increased risk. Unsecured loan examples include credit cards, student debt, and personal loans.
|Backed by collateral
|Not backed by collateral
|Risk for lender
|Involves collateral valuation
|Credit score requirements
|May be less strict
|May be more strict
|Mortgages, home equity loans, auto loans
|Personal loans, credit card loans, student loans
Lenders generally reward you with more favourable loan terms for collateralizing a safer asset. An asset is deemed safer if it's easy to sell, less mobile, and won't sharply drop in value. For this reason, collateralizing your home will almost always have the best lending conditions.
Lending conditions are the characteristics of your loan, such as your interest rate, loan-to-value, and term length. Collateralizing safer assets entitles you to a lower interest rate, higher loan-to-value, and extended term length. Riskier assets have the following loan characteristics;
The remainder of this section will walk you through the six main types of secured loans and explain them in detail.
A mortgage is the most common type of collateral. It's Canada's most popular way to finance a home purchase. A mortgage is secured against your property, which means that if you don't make monthly payments, the lender can repossess your home through a power of sale process.
During the mortgage approval process, lenders will thoroughly assess the home to ensure it's good collateral. This includes an appraisal, title search, and insurance. As a result, the application process is more complex, and it can take a while to get approved.
The mortgage lender will become the primary lien on your home. This means they have the first claim on your home if you default on your mortgage payments and need to sell the property. However, since a house is easy to sell, immovable, and won't rapidly drop in price, lenders deem it not risky. As a result, you'll get the lowest interest rates when collateralizing the first lien of your primary residence. If you already own a home and want to borrow against it, you can use a cash-out refinance.
Home equity is how much of the home you own. It is the difference between the market value and the total amount borrowed against the house. Most likely, your home equity will increase over time due to paying off your mortgage and increases in the home value. You can borrow against it using a variety of secured loans.
While a mortgage is a primary lien on your home equity, many products let you borrow on the remaining home equity. These are second mortgages because in the event of default, these lenders get their money after the primary lender is paid. As a result, these tend to have slightly higher interest rates than a mortgage. The most popular second mortgages include:
If you own a car, you can secure an auto loan against it. Auto loans are typically the shortest term of all collateralized loans and come with higher interest rates. This is because it's riskier for lenders to secure a car since it can drive away. Borrowers may only need to make payments for up to five years before owning the car outright.
Your credit score and vehicle model will be essential in determining the interest rate you qualify for. Additionally, lenders may also look at your debt service ratios, which compares your debt with your total income. There are two main types of auto loans.
High-net-worth individuals with access to private banking can collateralize many personal assets. Boutique securitized loans will let you borrow against items such as:
However, in many cases, these assets are difficult to value and have high appraisal fees. Additionally, these assets are risky for lenders translating to less favourable loan characteristics. Unlike homes, these assets are portable, difficult to sell, and have the potential to drop rapidly in value. Lenders will offer lower LTVs, shorter term lengths, and higher interest rates to compensate for the increased risk.
Some boutique lenders may even allow you to cross-collateralize assets. Instead of using one asset per loan, you can secure multiple loans with a bundle of various assets. For example, you could use some of your artwork as additional collateral for a loan against your investments. However, this means you are taking on more risk because lenders can seize multiple assets in the event of default.
While individuals can collateralize personal items, businesses can do the same with commercial items. Companies can use a variety of assets as collateral for a loan, including:
Famously, Ford collateralized their logo in 2006 for a $23.5 billion loan to avoid bankruptcy. This also included the trademarks for the Mustang sports car and F-150 pickup. Note that securities and intellectual property collateralization are typically reserved for larger businesses. This is due to the high costs required to value the assets.
Otherwise known as a credit builder loan, these are the safest option for lenders. This is because you typically secure the card with a cash deposit, ensuring that lenders are protected if you default on your loan.
In most cases, the card has a 0% loan to value, meaning the lender doesn't provide you with any of their money. For example, if you deposit $1,000, this would become your credit limit. Any late payments are charged at a standard APR of 19.99%.
This means you are lending to yourself but paying interest to someone else. You can receive your deposit back by closing the account or switching your card to an unsecured variant.
The main benefit of a secured credit card is that it helps you kick start building a credit score. This can be particularly useful if you have a low income or have yet to be able to establish credit.
The requirements for secured loans will vary depending on the lender and the type of asset you use as collateral. However, there are some basic requirements, such as government identification and exceeding the age of the majority. In addition, lenders will assess your application using three categories.
Credit score plays an integral role in the secured loan application process. It is used to assess a borrower's creditworthiness and ability to repay the loan over its term. Generally, lenders will require a minimum credit score for approval. With a higher credit score, you appear to be a safer borrower. As a result, you’ll likely receive lower interest rates and higher LTVs.
The collateral you offer as security for the loan is also essential in determining your approval eligibility. Typically, secured loans will require some property or asset that can be liquidated in the event of default, including real estate, vehicles, or other physical assets. You will receive a higher LTV if the collateral is not portable, and easy to sell.
Lenders will also assess your ability to make repayments on the loan. This means examining your credit history and evaluating your current income and expenses. Sometimes, you may need to provide proof of employment or a letter from your employer detailing your income.
You should now understand what type of secured loan you are looking for. This section will explain your options on where to find them.
These lenders have the most challenging qualification process and the least flexible options. They typically offer low LTVs and charge higher interest rates. However, they offer some of the most secure terms compared to other lenders. Banks are the toughest lenders to receive funding from.
These lenders are popular alternatives for borrowers who want a fast approval process and more accessible qualifications. Online lenders often offer lower loan-to-value ratios and lower interest rates, though their terms may not be as secure as those of a bank.
Credit unions are nonprofit organizations that provide financial services to their members. They offer some of the lowest interest rates and often have flexible terms for borrowers depending on your creditworthiness.
You can get a secured loan even with bad credit; secured loans are easier to get with bad credit than unsecured loans. Private mortgage lenders offer second and even third mortgages to homeowners. Some lenders have no minimum credit score required to get a loan, and some do not check your credit score.
Private lenders are also not required to conduct a stress test when you apply for a mortgage with them. The amount of equity you have in your home is looked at more closely. Having equity can let you get a loan even with bad credit. However, loans from private lenders have much higher mortgage interest rates and fees.
Student loans can be either secured or unsecured, depending on the type of loan that you take out. Federal student loans are generally secured since you can’t default on them. On the other hand, private student loans are typically unsecured since they do not have any collateral backing them.