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If you’re applying for a loan you may be asking yourself “what is collateral?” This is a timely search as business loans increase in popularity. In 2020, only 48% of small businesses said their financial needs were met. Although there has been an influx of federal funding options due to COVID-19, it’s best you are familiar with other options out there. But what is required from you? Loan terms can be confusing on their own without the added worry of loan collateral. Fortunately, not all loans require collateral. However, the loans that do require it to secure funding generally come with lower interest rates. If you default on a collateralized loan, the lender can seize the asset put up as collateral, so this is an important decision for your business. To better understand how the collateral for a loan works, we first must define loan collateral.
What is Collateral?
So, what is collateral? Loan collateral refers to any asset a borrower uses to secure funding, kind of like insurance for a loan. Collateral may take the form of a vehicle, equipment, or real estate, depending on the purpose of a loan. The collateral serves to protect the lender in the event the borrower defaults on their loan payments. If this occurs, the lender can recoup their losses by seizing the asset used as collateral for the loan.
How Collateral Works
Before a lender issues a loan, they will need to know if you can repay the financing. Therefore, it helps to offer some type of security. By offering an asset for security, the borrower ensures the lender that they will repay the loan, as promised. In the event of default, the lender has the right to seize the collateral and sell it, thereby applying the money to the unpaid loan amount.
Normally, a collateralized loan involves real estate or a vehicle. For example, real estate represents the collateral for a mortgage loan while a vehicle serves as collateral for an auto loan. You can also secure a credit card by providing collateral in the form of a cash deposit–an amount that represents the credit limit for the card. This amount ranges, on average, between $200 and $500.
When a lender lays claim to the collateral of a borrower, they place a lien on the asset to satisfy the lending debt. Needless to say, borrowers feel more compelled to repay a collateralized loan, as they stand to lose the assets pledged as collateral.
The Different Types of Loan Collateral
As noted, the type of collateral used for a loan depends on the type of financing. Usually, the primary sources of collateral include real estate, savings, inventory, and equipment.
Mortgages used to finance real estate use property to secure the loan amount. If the purchaser defaults on the loan, they may go into foreclosure and lose the property. REO properties represent bank-seized properties that have not yet been sold. Most banks find it hard to sell or auction foreclosed property. Therefore, they often try to work with the borrower to find a way to reclaim the debt first.
You can use your savings, usually tied to a Certificate of Deposit (CD), to obtain a savings secured loan. By using this type of collateralized loan, you can still accrue interest on the CD while repaying the loan amount. Because you secure the funding with your savings, you cannot withdraw the money, whether from a CD or a savings account, until you repay the loan in full.
When you take out a loan or secure financing with your business’s inventory, you are using a short-term loan solution to buy items that you need to sell. If you need to place a large order for inventory but cannot afford the expense, you can take out an inventory loan and repay off the loan amount as you sell the products.
When a business needs equipment, it may use the equipment it’s buying as collateral for the assets. When you take out these collateral loans, you pay back the financing, which includes principal and interest, over a fixed period.
Once you pay the loan in full, you own the equipment free and clear. Some equipment loans may also place a lien on other business assets or require a personal guarantee. If an executive in a business provides a personal guarantee, they must pay the debt personally if their business cannot cover the debt.
The Loan Types that Require Collateral
The business loan types that require collateral include mortgages, secured personal loans, secured credit cards, and auto loans.
Mortgages are a classic example of a collateralized loan, as they always use real estate to secure the loan amount. Therefore, getting prequalified for a mortgage loan enables you to see just how much you can afford to pay.
In some cases, mortgages may be used to refinance real estate. Whether the funding involves buying real estate or refinancing it to make an improvement, mortgage financing facilitates the transaction.
Most people who buy real estate do so with a mortgage. Even if an investor has the money to pay for a property, they may finance a real estate purchase with a mortgage to free up their money. To qualify for a mortgage loan, you must have a dependable and stable income and a decent credit score (at least 620 for conventional financing and 580 for FHA loans). Additionally, your debt-to-income ratio must fall under 50%.
If you stop making payments on the real estate, the lender can take possession of the property through foreclosure to secure the unpaid balance.
Secured personal loans
Secured personal loans are those that use different types of collateral to secure the loan amount. Usually, secured personal loans come with a lower interest rate. They may be used for emergency cash or for any other purpose whenever you need a quick money loan.
Some of the items used as collateral for secured personal loans include cars (car titles on paid vehicles), boats, motorcycles, RVs, and trucks. You can also use life insurance, savings accounts (including CDs), investments, precious metals, art, or jewelry to take out this type of financing.
Secured credit cards
If you need credit but have a poor business credit score or a short credit history, you can obtain credit through a secured card. What you pay as a deposit to secure the credit card serves as the credit line for the card.
For example, if you get a secured card with a credit line of $200, it means you funded the card with $200. To get the money back you used for the credit line, you must pay off the card in full. If you fall into default, the amount you placed toward the card will be used to cover the unpaid amount.
Auto loans represent yet another type of collateralized loan. Therefore, you can usually buy a car without showing proof of employment or revealing other financial details. Because the car can be repossessed if you do not repay the loan, the lender or car dealer can recover the loss fairly easily. Therefore, you can obtain an auto loan relatively fast.
Can You Borrow without Collateral?
Truthfully, you can borrow money without needing to put up collateral. If you have problems with credit, you can always use a co-signer with a good credit rating to secure an uncollateralized loan or unsecured financing.
Unsecured loans include student loans, personal loans, and credit cards. When you do not use collateral to secure a loan, the lender must rely primarily on your credit score. Because these loans come with a greater risk of default, they generally have higher interest rates.
When taking out a loan, it pays to know the differences between uncollateralized and collateralized loans. Most loans require collateral if you want to pay a lower interest rate. Whatever type of loan you choose, make sure you keep up on your payments. Doing so can increase your chances of better lending opportunities down the road. The goal of any type of financing is to prep you for success, not submarine your business. Keep this in mind when researching your loan options.