With reference to lending, security or collateral, is an asset that is pledged by the borrower as protection in case he or she defaults on the repayment, not paying some or all back.
Under the loan agreement, the lender could have the right to take ownership of the asset in place of the repayment, or he or she might have the right to insist that the asset is sold to repay the outstanding loan and interest (and perhaps other unpaid expenses), with the remainder of the proceeds returned to the borrower.
Security should be important to the lender, whether the borrower is an individual or a company. Without it, the lender might not be able to recover the money lent, however tough the terms of the loan agreement.
When you apply for a loan, lenders assess your creditworthiness to determine the risk of lending money to you. One way to improve your chances of approval and get better loan terms is to offer collateral or security for the loan.
Collateral serves as protection for the lender in case you are unable to repay the loan as agreed. By pledging an asset as security, you provide reassurance that the lender can seize and sell the asset to recover their money if you default.
In this comprehensive guide, we’ll explain what collateral is the most common assets used the pros and cons of secured loans, and tips for reducing your risks when putting up security for a loan.
What Is Meant by Security on a Loan?
With loans, security refers to an asset pledged by the borrower to the lender in case of default. This security is called collateral which minimizes the risk for lenders by ensuring that the borrower keeps up with their financial obligation. The borrower has a compelling reason to repay the loan on time because if they default they stand to lose their home or other assets pledged as collateral.
Loans requiring collateral are called secured loans The collateral gives lenders recourse if the borrower stops making payments They can seize and sell the asset to recover the outstanding loan balance.
Conversely, loans without collateral are unsecured. They carry more risk for lenders, so tend to have higher interest rates and more stringent eligibility requirements.
What Assets Can Be Used as Collateral for Loans?
The most common assets used as collateral for loans include:
-
Real estate – Primary residences, second homes, investment properties. The property serves as security for mortgages and home equity loans.
-
Vehicles – Cars, motorcycles, RVs, boats. The vehicle itself secures the loan in cases like auto loans and boat loans.
-
Savings and investments – Cash accounts, stocks, bonds, mutual funds. These liquid assets easily convert to cash.
-
Equipment – Machinery, tools, electronics. Often used as collateral for small business loans.
-
Valuables – Jewelry, collectibles, antiques. Common collateral for pawn loans.
-
Insurance policies – Life insurance cash value. Accessible through policy loans.
Lenders prefer collateral that is easy to value, liquid, and easy to claim if necessary. Real estate and vehicles generally make ideal collateral for this reason.
What Are the Benefits of Providing Collateral for a Loan?
Securing a loan with collateral offers several potential advantages:
-
Better rates and terms – Secured loans tend to have lower interest rates because the collateral reduces the lender’s risk.
-
Higher approval odds – Providing collateral improves the likelihood of getting approved, especially if you have poor credit or limited credit history.
-
Ability to borrow more – With collateral in place, lenders may be willing to offer larger loan amounts.
-
Faster funding – Loans with collateral can often be funded more quickly than unsecured loans that require more underwriting.
-
Build credit – Making on-time payments can help secured loans improve your credit score over time.
What Are the Potential Drawbacks of Collateralized Loans?
While beneficial in many cases, using collateral for a loan does come with some downsides to consider:
-
Risk of losing assets – If you default, you could lose valuable property like your home or car.
-
Difficult to walk away – The collateral obligation makes it harder to walk away from an unaffordable loan.
-
More paperwork – Additional documentation and legal procedures to pledge and claim collateral if needed.
-
Limitations on the asset – Your lender may restrict usage or transfers of collateralized property until the loan is satisfied.
-
Foreclosure expenses – You may owe lender fees if they have to foreclose on real estate collateral.
-
Prepayment penalties – Secured loans often charge fees for early repayment, limiting flexibility.
Tips to Reduce Risks When Using Collateral for a Loan
If you decide to move forward with a secured loan, keep these tips in mind to minimize risks:
-
Only use assets you can afford to lose as collateral. Avoid pledging necessities like your primary home when possible.
-
Take out the minimum loan amount needed so your obligation is lower if you struggle to repay.
-
Select the shortest feasible loan term so collateral is at risk a shorter period.
-
Shop around for the best rates and terms, don’t just accept the first loan offer.
-
Ask the lender to include a clause allowing you to substitute collateral later if needed.
-
Consider gap insurance for financed vehicles to cover any shortfall between loan balance and insurance payout.
-
Make payments on time and repay as quickly as possible to limit interest costs and release your collateral.
What Are Your Options If You Don’t Have Collateral?
If you need a loan but have no assets to secure it, look into unsecured loan options including:
-
Personal loans – Unsecured loans from banks, credit unions and online lenders. Amounts up to $40,000 or more.
-
Credit cards – Revolving credit lines without collateral. Useful for smaller or short-term borrowing needs.
-
Payday loans – Risky but fast unsecured loans up to $500 or so. Should be a last resort option.
-
Guarantor loans – Unsecured loans where a third-party co-signer guarantees repayment if you default.
-
Peer-to-peer loans – Borrow from individual investors. Offer lower rates than payday loans.
-
401(k) loans – Borrow against your own retirement savings. Must be repaid to avoid taxes and penalties.
While unsecured loans present some advantages, expect to pay higher interest rates and potentially submit to credit checks or income verification. Lenders need to mitigate the higher default risk they take on without collateral.
The Bottom Line
Putting up collateral for a loan can be advantageous when you need access to affordable financing but have poor credit or limited borrowing history. Pledging an asset as security also allows you to borrow larger amounts than unsecured credit lines.
However, secured loans aren’t without drawbacks. You could lose your home, car or other valued property if you fail to repay as agreed. And they offer less flexibility with prepayment penalties and obligations tied to the collateral.
If you move forward, take steps to minimize risk. Only pledge assets you can afford to lose, shop for the best terms, make timely payments, and repay early if possible. Also consider unsecured loans or alternatives like credit cards if willing to accept higher rates without collateral.
Carefully weighing the pros and cons will help you make a prudent borrowing decision that improves your financial situation without undue risk. With proper precautions, using collateral can provide affordable access to financing that may be difficult to obtain otherwise.
What types of assets are commonly used as security?
The lender will want to make sure that the asset is at least as valuable as the outstanding loan, so that if the borrower defaults, the loan can be repaid.
Often the asset that the borrower buys with the loan is used as security. However, some assets (new vehicles being a very good example) devalue immediately after purchase. For these types of purchases, the lender often requires the borrower to make a deposit that reduces the loan amount below the second-hand value of the security.
The lender is also likely to insist on an independent valuation or confirmation of value.
From the lender’s point of view, the more easily the asset can be acquired and sold, the less risky it is to lend against it. Stock may be easy to sell (provided it is not perishable or out of date), where as heavy, fixed specialist machinery may be difficult to acquire from the debtor and difficult to sell on.
The security could be an intangible asset, such as shares in the lending company, or the right to receive a debt owed by someone else. Generally, these are harder to value, and therefore riskier to accept.
We cover in more detail what to choose as security on a loan to a company.
In the UK, a lien against real property in legal jargon – using land and buildings as security – requires a solicitor (for no other good reason than to protect the solicitors’ monopoly on conveyancing transactions). To secure a loan against any other asset, you don’t need a solicitor to be involved.
Some assets may already have be used as security. For example, if a family member is buying a house, and you are lending money for the propertys deposit, the mortgage provider will have preferential rights over the proceeds from sale.
If the borrower defaults, the mortgage provider is not under any obligation to sell the property at market value (it just will want the outstanding loan, interest and charges), so you may not receive your loan back. For any given asset, there may be a number of lenders who have preferential rights to be repaid before you, so check who else has a lien.
In addition to securing the loan against an asset, a lender might (we would argue that the lender should) also ask that a company or one or more people act as guarantor. A guarantor gives an additional degree of security. If the borrower defaults, the lender may pursue the guarantor for the whole debt, or any part of it. A guarantor therefore reduces the risk that the second hand sale value of the asset might be less than the debt outstanding.
Savings Secured Loan, EXPLAINED!
FAQ
What does security on a loan mean?
What security is required for a loan?
What can be offered as security for a loan?
What is security held for loan?