What is the Collateral for a Car Loan?

When you take out a car loan to finance the purchase of a new or used vehicle, the car itself serves as collateral for the loan This means that the lender can repossess the car if you default on the loan and fail to make payments Understanding how collateral works with auto loans can help you make smart financing decisions when buying a car.

What is Collateral?

Collateral refers to an asset that a borrower pledges as security for a loan. If the borrower stops making payments on the loan, the lender can seize the collateral to recoup their losses

Common types of collateral include

• Homes for mortgages
• Cars for auto loans
• Cash accounts for personal loans
• Business assets for small business loans

Lenders prefer to make secured loans that are backed by collateral because it reduces their risk. If the borrower defaults, the lender can take ownership of the collateral and sell it to cover the remaining loan balance.

How Collateral Works with Car Loans

With a car loan, the vehicle you are financing serves as collateral securing the debt. The lender places a lien on the title, giving them the legal right to repossess the car if you stop making payments.

When you buy a new or used car from a dealership, the dealer will help arrange financing. Most auto loans are secured loans, meaning you need to put up collateral. Used car loans may be unsecured in some cases, but will carry higher interest rates.

The loan amount will be based on the vehicle’s value. The lender will not lend more than the car is worth, as that increases their risk. Many lenders cap auto loans at 120% of the car’s value.

During the loan term, you are making payments towards ownership. The lien remains on the title until the loan is paid off. Then the lender removes their lien and you have the full, unencumbered title.

If you want to trade in or sell the car before paying off the loan, you will need to satisfy the lien first. This means coming up with the cash to pay off the remainder of the loan balance so that the lender will release their lien.

Consequences of Defaulting on an Auto Loan

Defaulting on your auto loan payments has serious consequences, the most severe being repossession of the vehicle. Here is what happens if you fall behind on payments:

• Late Fees: After missing one payment, the lender will charge a late fee, typically around $25-$50.

• Delinquency: After 30 days of no payment, the loan becomes delinquent. Expect additional late fees.

• Default: If delinquent for 90 days, the loan goes into default status. At this point the lender can pursue legal action.

• Repossession: The lender can send a repo agent to seize the car, usually between 90 to 120 days past due. You will be responsible for repo fees too.

• Deficiency Balance: If the car sells at auction for less than what you owe, you are responsible for the deficiency balance.

• Credit Damage: Missed payments will be reported to credit bureaus, damaging your credit score.

• Lawsuits & Wage Garnishment: The lender can sue you for the remaining balance and garnish your wages.

Clearly, you want to avoid default at all costs. If you are having trouble making payments, it is imperative to communicate with the lender right away. You may be able to negotiate modified payment arrangements.

Benefits of Using a Car as Collateral

While defaulting is disastrous, using your car as collateral provides some advantages when financing:

• Lower Interest Rates: Secured loans have lower interest rates, saving you money over the loan term.

• Larger Loan Amounts: Lenders will approve larger loan amounts with collateral backing the debt.

• Longer Terms: Car loans can be extended over 5 or 6 years with collateral, versus 2-3 years for unsecured personal loans.

• Build Credit: Making on-time payments helps improve your credit score over time.

• Buy Now: Secured financing allows you to buy and drive the car right away while making payments.

As long as you carefully consider the monthly payment in relation to your budget and make payments on time, using the car as collateral for an auto loan can be beneficial.

What Assets Lenders Accept as Collateral

Cars are one of the most commonly used assets for collateral loans. But lenders accept various other types of property as security. Typical collateral includes:

• Bank Deposits – Savings and CD accounts funds can collateralize personal loans.

• Investment Accounts – Brokerage accounts and 401ks may be accepted.

• Real Estate – Houses or land can be used for mortgages and home equity loans.

• Equipment – Business equipment and machinery make good collateral for business loans.

• Insurance Policies – Certain insurance plans have cash value to collateralize loans.

• Jewelry & Artwork – Valuable personal property may be used for pawn loans or cash advances.

• Securities – Stocks and bonds can be collateral for personal loans with some lenders.

The asset must have sufficient appraised value to secure the loan amount. Lenders will also consider how easily they could sell the item if a borrower defaults. Cars, real estate and cash accounts tend to be preferred collateral with clear resale value.

Is a Person’s Home Accepted as Collateral for an Auto Loan?

Using a home as collateral for a car loan is very uncommon. Home equity loans or lines of credit can provide funds to purchase a car. But auto lenders will not place a lien on your house. There are a few reasons why:

• Mortgage Banks Have First Lien – The primary mortgage lender has first claim on your home equity.

• Overcollateralization – A home is usually worth much more than a car, so it is overkill for collateral.

• Recourse Difficulties – It may be difficult for an auto lender to foreclose and take possession of a home.

• Regulatory Compliance – Dodd-Frank regulations make it difficult to use a home as collateral outside of mortgages.

In most cases, your house is off limits when it comes to collateral for an auto loan. The car itself (or another vehicle you own free and clear) will be required as security for the financing.

Can You Use Someone Else’s Car as Collateral?

Borrowing against someone else’s paid-off car is possible, but can be tricky. Some potential scenarios:

• Co-Signing: If a friend or relative co-signs the auto loan, their car could potentially be used as collateral.

• Business Partners: Business partners may allow using a company car as collateral for a personal loan.

• Joint Ownership: If you jointly own a car with someone, the jointly owned asset could collateralize a personal loan in some cases.

• Spouses: Your spouse may need to sign over power of attorney to use their car for collateral if solely in their name.

The owner would need to agree to pledge their vehicle as security for your loan. They take on substantial risk, as their asset could be repossessed if you default. Most lenders will also want to add them to the loan contract.

Borrowing against someone else’s car comes with pitfalls. It requires complex legal arrangements and places the owner’s asset at risk. For ordinary auto loans, each borrower needs to use their own car or purchase the car jointly.

Are Retirement Accounts Accepted as Collateral?

Retirement accounts like 401(k)s and IRAs have strict IRS rules regarding withdrawals and loans. As a result, lenders are typically reluctant to accept retirement savings as collateral for a personal loan, including auto loans.

In very rare cases, an IRA could potentially be used if you take a distribution from the account. But that triggers taxes and penalties, so it is not recommended. Most lenders will not allow 401(k) loans as collateral either.

It is best to leave your retirement savings protected. If accessing funds to purchase a car, make a standard 401(k) loan if allowed by your plan, or use non-retirement assets for collateral. Retirement accounts are meant for your future, not car loans.

Takeaways on Collateral for Auto Loans

The key points to understand about collateral with car loans:

• The purchased vehicle serves as collateral securing the loan.

• The lender can repossess the car if you default on payments.

• Using the vehicle as collateral allows you to qualify for better loan terms.

• Make payments on time to build credit and maintain ownership.

• If you must default, communicate with the lender immediately to try to avoid repossession.

• Homes and retirement accounts cannot be used as collateral for car loans.

Keeping these tips in mind will ensure you make wise decisions when using a car as collateral to finance your next vehicle purchase.