What Do Borrowers Use to Secure a Mortgage Loan? A Comprehensive Guide

Getting a mortgage to purchase a home is an exciting yet daunting process. As a borrower, you’ll need to provide collateral to secure the loan and prove to the lender you can repay it. But what exactly do you use as collateral for a mortgage?

When you take out a mortgage, the home itself serves as the collateral. This means if you default on the loan, the lender can seize the home through foreclosure and sell it to recoup their losses.

Using your new home as collateral for the mortgage loan is standard practice. Read on to learn more about how collateral works with mortgages, the pros and cons, and what happens if you default.

What is Collateral and How Does it Work?

Collateral refers to an asset or property offered to secure financing like a mortgage or loan. If the borrower fails to repay the debt, the lender can legally seize the collateral to make up for the losses.

For a mortgage the home you’re purchasing with the loan serves as the collateral. The lender places a lien on the property until you pay off the loan. This gives them the right to foreclose and take ownership if you default on payments.

While the home is almost always used to secure a mortgage, sometimes borrowers can offer additional assets if they don’t meet eligibility requirements. For example, a borrower with poor credit or high debt-to-income ratio may need to put 20% or more down and use investments or other real estate as added collateral.

Offering valuable collateral makes lenders more willing to approve borrowers for larger loan amounts with lower interest rates The collateral helps reduce their risk

The Benefits of Using Your Home as Collateral

Using your new home as collateral provides several advantages compared to unsecured loans:

• Higher Loan Amounts – Lenders will loan more money when it’s backed by collateral Mortgage loans typically range from $50,000 to over $1 million

• Lower Interest Rates – Secured loans have lower rates, often starting under 5% for mortgages. Rates for unsecured loans are usually much higher.

• Longer Repayment Term – Mortgages have extended 15 to 30-year payment terms versus 2 to 7 years for unsecured loans. The longer term keeps payments affordable.

• Build Home Equity – Monthly mortgage payments let you build equity in the home over time. You can tap this equity later via home equity loans and lines of credit.

• Usually Fixed Payments – Most mortgages have a fixed rate and payment amount. This locks in affordability over the life of the loan, unlike adjusting payments of unsecured loans.

For most borrowers, the home they’re buying is sufficient collateral for lenders. Having a single asset backing the mortgage simplifies the lending process.

Potential Disadvantages of Using Your Home as Collateral

While offering your new home as collateral has many advantages, there are also some potential drawbacks borrowers should keep in mind:

• Risk of Foreclosure – If you default, the lender can foreclose on the home and force a sale to recover their losses. You’d lose both the house and equity invested.

• Difficulty Getting Financing if Self-Employed – Lenders more closely scrutinize self-employed borrowers. You may need to offer additional assets as collateral to get approved.

• Inability to Move Easily – Defaulting makes it harder to sell or refinance the home until you resolve the situation. The property’s lien status must clear first.

• Credit Damage if You Default – Missed mortgage payments show up on your credit reports and can significantly lower your credit score for years.

• Closing Costs and Fees – You’ll pay home appraisal fees, application fees, title fees and other closing costs with a mortgage versus minimal or no fees for unsecured loans. Plan for closing costs to equal 3-5% of the mortgage.

• Lengthy Application Process – Obtaining a mortgage takes more time as lenders thoroughly evaluate your income, assets, credit and ability to repay. Be prepared for a 30-45 day process.

As long as you can comfortably handle the monthly payment, using your home as collateral is usually the smart choice. Just be cautious taking on too much house or debt compared to your income.

What Happens if You Default on Mortgage Payments?

Defaulting on a mortgage sets off a legal process that could end with foreclosure. Here are the general steps if you can’t make payments:

• The lender sends a demand or breach letter after 30 days of nonpayment

• Between 90-120 days past due, the lender files a notice of default with the county to start the foreclosure process

• You enter a grace period where you can negotiate alternate payment arrangements, loan modifications or try to sell the home yourself

• If you don’t resolve the default, the lender petitions the court for a foreclosure judgment after 6-12 months

• The court schedules a foreclosure auction of the home where the lender and other interested parties can bid

• If no third party buys it, ownership reverts to the lender and they sell it themselves later to try recovering their mortgage investment

• Deficiency judgments are possible in some states if sale proceeds don’t cover the loan balance owed

This legal process can take 6 months to 2+ years depending on state laws and housing market conditions. You have time to try saving your home by working with your lender. But foreclosure devastates your credit for years. Avoid it if possible.

Alternatives if You Don’t Want to Use Your Home as Collateral

For borrowers who don’t want to risk foreclosure, there are a couple alternatives to a traditional mortgage:

Rent-to-Own Agreement – Find a home seller willing to let you rent the home for 1-3 years with an option to purchase. Rent payments build your equity. Once ready to buy, obtain financing or pay the seller directly.

Lease-Option Agreement – A long-term lease establishing right of first refusal to buy. As renter you aren’t obligated to purchase but gain time to improve credit or save more for a mortgage down payment.

Margin Loan – A loan from a broker using your investment portfolio as collateral instead of real estate. This avoids foreclosure risks but gives brokers access to manage your investments.

Hard Money Loan – A short-term loan issued by private investors at higher rates, but with the home and/or land used as collateral. Pay off within 6-12 months by refinancing into a standard mortgage.

Buy Home Outright – Purchase the property with cash from your savings or other assets if you can pay asking price. There’s no mortgage or risk of foreclosure without financing.

These options have their own pros, cons and risks to weigh. For most homebuyers, though, a traditional mortgage with the home as collateral is the most viable route to financing a property. Just be sure you can handle the required monthly payments.

How Much House Can I Afford?

As a first step, get preapproved by a lender to determine your maximum affordable home price. Preapproval analyzes your:

• Income – Verify gross wages and other earnings with paystubs and tax returns

• Assets – Bank statements show savings for down payment and closing costs

• Credit – Minimum 620 FICO score for conventional loans; higher scores get the best rates

• Debts – Total monthly payments on credit cards, student loans, auto loans, etc.

Based on these factors, the lender calculates the loan amount and home value within your budget. This prevents disappointment and wasted time touring homes priced too far above what you can realistically borrow and repay comfortably.

Ideally, total monthly housing costs including mortgage principal, interest, taxes and insurance (PITI) should not exceed 28-30% of your gross monthly income for conventional loans. Debt-to-income ratio including all monthly debts shouldn’t be higher than 36%.

Getting Preapproved for a Mortgage

Here are some steps to take for getting preapproved:

• Check your credit reports and FICO scores so you know where you stand before applying

• Research mortgage rates and lending requirements through sites like Bankrate and HSH.com

• Get rate quotes from multiple lender websites to compare

• Compile copies of paystubs, W-2s, tax returns, bank/investment statements to verify income and assets

• Complete a loan application with your chosen lender

• Authorize the lender to pull your credit reports

• Provide any additional requested documentation

It takes about 1-2 weeks to receive a preapproval letter after submitting a complete application with all documentation. Now you can confidently start touring suitable homes up to your preapproved amount knowing what you can afford.

How Much Down Payment is Needed?

Down payment requirements vary by loan type:

• Conventional – Typically 10-20% down to avoid private mortgage insurance

• FHA – Minimum 3.5% down payment

• VA – No down payment for qualified veterans; funding fee applies

• USDA – No down payment for low/moderate income in rural areas

Come ready with both down payment funds and closing costs, which average 4-5% of purchase price. Avoid draining long-term savings or retirement accounts to come up with the down payment. Utilize low-interest savings/CDs or gift funds from family only.

Closing the Deal and Securing the Mortgage

Once you find the perfect home and have an offer accepted, it’s time to close and secure financing. Final steps include:

• Processing loan approval with the lender

• Completing purchase agreement terms like home inspection, appraisal, etc.

• Reviewing and signing final closing disclosure documents

• Transferring down payment and closing cost funds to escrow account

• Signing paperwork to activate promissory mortgage note and lien

• Taking ownership and getting keys at closing!

Having a complete understanding of the collateral process before starting your home search makes achieving homeownership go more smoothly. Seek preapproval and real estate agent representation early. Follow the above steps to use your new home successfully as collateral for your dream property.