Collateral for Car Loans: Everything You Need to Know

Getting a car loan often requires putting up collateral. Collateral is an asset that the lender can seize if you default on the loan. For auto loans, your new vehicle typically serves as the collateral. Understanding how collateral works with car loans can help you make the best financing decision when purchasing your next vehicle.

What is Collateral on a Car Loan?

Collateral is an asset that a borrower pledges to the lender to secure a loan. If the borrower stops making payments, the lender can seize the collateral, sell it, and use the proceeds to recover their losses.

For auto loans, the vehicle you are purchasing serves as the collateral. The lender places a lien on the title, meaning they have a legal right to take possession of the car if you default. Essentially, the lender owns your car until you finish making payments and pay off the loan.

Using your new car as collateral benefits borrowers in a few key ways

• Larger Loans – The lender can comfortably offer larger loan amounts since they can take the car. This allows you to purchase more expensive vehicles that may be out of reach with unsecured financing.

• Lower Rates – Secured loans have less risk for lenders, so they can offer better interest rates, often 1% to 3% lower than unsecured options.

• Easier to Qualify – Even borrowers with poor credit stand a chance at qualifying for a secured car loan, The lender focuses more on the car’s value rather than just your credit score and income

However, defaulting on a secured auto loan also puts your vehicle at risk The lender can repossess your car if you miss payments But for most buyers, the pros outweigh that potential downside.

How Much Collateral is Needed?

Lenders generally require your new vehicle to be worth enough to fully collateralize the loan. However, some lenders finance as much as 125% of the car’s value. This allows you to roll taxes, fees, and extras like an extended warranty into the amount borrowed.

Used cars often need to be newer and have lower mileage to qualify as collateral. Many lenders set limits, such as:

• Vehicle is 10 years old or newer
• Has less than 100,000 miles
• Carry a minimum value, often $5,000 to $7,000

These requirements help ensure the lender can sell the used car for enough money to recover costs if repossessed. If your car is older or has high miles, you may need to look at unsecured financing options instead.

What if Your Car is Worth Less Than the Loan?

If you owe more on your loan than your car is worth, you have negative equity. This typically happens because vehicles depreciate rapidly. Your car could lose 20% to 30% of its value in the first year alone.

Negative equity makes your loan riskier for a lender. If they had to repossess and sell the car, they may not get enough money to cover the remaining loan balance.

You have a few options to handle negative equity:

Make extra payments – Paying down the principal faster than required cuts the gap between your loan and the car’s value.

Refinance – A refinance potentially lowers your rate, reducing interest charges. This gets you closer to breaking even.

Trade-in – Trading in the upside-down car rolls the negative equity into a new car loan.

Buy gap insurance – Gap insurance covers the difference between your loan and the car’s value in the event of a total loss.

Negatively equity makes it riskier for a lender to approve you for another auto loan. Having a solid credit score, low debt-to-income ratio, and significant down payment can improve your changes.

What Happens if Your Car is Repossessed?

When you use a car as collateral, the lender can repossess it if you fall too far behind on payments. Repossession laws vary by state. But generally, the lender must send written notices before repossessing the vehicle.

If you cannot catch up on the missed payments, the lender has the legal right to:

• Use a repossession company to take the car from where it is parked, whether public or private property
• Sell the vehicle and apply the money towards your loan balance
• Come after you for any remaining amount still owed
• Report the repossession to the credit bureaus, damaging your credit

Voluntarily surrendering your car can help avoid some of these consequences. You may also get a grace period to catch up if you communicate with the lender early about falling behind. But once the repossession process starts, it can rapidly snowball into a costly and credit-hurting situation.

Is Collateral Required for Car Loans?

Collateral is required for most standard auto loans. However, it is possible to get a car loan without collateral through an unsecured personal loan. These loans depend solely on your income and credit profile rather than using the car’s value.

Unsecured loans have some key differences:

• Typically top out around $40,000, limiting what cars you can buy
• Tend to have higher interest rates, often over 10%
• Require strong credit, 680+ FICO score
• Have more flexible uses since the money is not tied to a specific purchase

Very few lenders offer unsecured auto loans. So finding this type of financing can be challenging, especially with poor credit. For most borrowers, a secured car loan that uses the new vehicle as collateral is the best and easiest option. But unsecured loans provide an alternative if your situation calls for it.

Can a Car Serve as Collateral for Other Loans?

Yes, you can use your paid-off vehicle as collateral for other types of borrowing besides a purchase auto loan:

Auto Refinance Loan – Refinancing replaces your existing car loan with a new one, often at a lower rate. Your car still serves as the collateral.

Auto Equity Loan – These loans use the equity you have built up in your paid-off car as collateral. They tend to have higher rates than refinancing.

Title Loan – Title loans also tap your car’s equity but tend to charge very high interest rates. They allow you to borrow 25% to 50% of your car’s value.

Home Equity Loan – Some lenders accept cars in addition to home equity as collateral. This allows you to qualify for a larger loan amount or better terms.

However, it is generally best to avoid using your car repeatedly as collateral unless necessary. The more loans that your vehicle secures, the greater the risk of losing your car if you default.

Frequently Asked Questions

Can you get a car loan without collateral?

Most lenders require collateral for auto loans. But some lenders offer unsecured personal loans that can be used to purchase a vehicle without putting up the car as collateral. These unsecured loans have lower maximums and higher rates.

What if I wreck the car used as collateral?

You are still responsible for repaying the loan, even if you wreck the vehicle used as collateral. This is why gap insurance is recommended – it covers the gap between what your car insurance pays out and what you still owe.

Can a co-signer provide collateral for an auto loan?

No, co-signers cannot provide collateral. The lender will still place a lien against the vehicle purchased. A co-signer simply agrees to become responsible for repaying the loan if the primary borrower defaults.

Does a down payment reduce the collateral needed?

Yes, a larger down payment means less money is borrowed, so the collateral value required decreases equally. A 20% down payment on a $20,000 vehicle requires just $16,000 in collateral value rather than the full $20,000.

Can a lender take collateral besides my car for an auto loan?

Lenders generally only use the purchased vehicle as collateral on an auto loan. However, some lenders may consider other assets you own when approving you for the loan. But the car itself will be the collateral they place a lien against.

The Bottom Line

Putting up collateral is necessary to get approved for most car loans. Pledging your new vehicle as security for the loan results in larger approvals, better rates, and more options for borrowers, particularly those with poor credit. While defaulting introduces the risk of repossession, collateral allows more people the chance at financing for a reliable vehicle.