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Everything You Need to Know About Collateral Loans

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When you need cash for a major expense, it might be tempting to borrow from a payday lender or max out a credit card. But you have other options that won’t harm your credit or put you in a cycle of debt — even if your credit isn’t all that great.

Collateral loans could be a way to borrow the money you need. Here’s how they work.

What Are Collateral Loans?

When you take out a loan from a bank or other financial institution, it’s generally either secured or unsecured. You can secure the loan by offering some form of collateral in return, known as a collateral loan, or a secured loan. You can also borrow without any collateral to back the loan, known as an unsecured loan.

With a secured loan, the lender can take possession of the asset if you’re unable to pay the loan back. This presents a bigger risk to you as a borrower, but it decreases the risk on the lender’s part. For this reason, secured loans can be easier to get approved for and can also be less expensive.

[Read: The Best Mortgage Lenders of 2018.]

Examples of secured loans include mortgages or auto loans, where your home or car serves as the collateral. You can also get a secured personal loan, which can be used for a variety of reasons, such as paying for a big-ticket item or consolidating credit card debt.

According to James Garvey, CEO and co-founder of Self Lender, a company that offers credit-builder loans, collateral loans are best for those who need short-term liquidity. However, he notes, “You need to own your car, house or other valuable asset” to borrow against.

Pros and Cons of Collateral Loans

Though using a collateral loan can be an effective way to borrow money, there are some risks that don’t exist with other types of loans. The major advantages of a collateral loan are:

You’re more likely to be approved. If you’re having a tough time getting a loan, perhaps due to credit issues or a short credit history, securing a loan with collateral could help reduce your risk as a borrower.

You might qualify for a larger loan. Similarly, since you are reducing the lender’s risk by offering up collateral, you might qualify to borrow more than you would otherwise.

It provides short-term liquidity. If all your money is tied up in assets that aren’t easy to convert into cash, such as a home or valuables, a collateral loan can help you get your hands on money without having to go through the cumbersome process of selling those assets.

On the other hand, there are some disadvantages to collateral loans:

You can lose the collateral if you don’t pay the loan back. The biggest risk of a collateral loan is you could lose the asset if you fail to repay the loan. It’s especially risky if you secure the loan with a highly valuable asset, such as your home.

It requires you to have a valuable asset. Another potential issue is that you have to have something valuable to offer as collateral in the first place. With an unsecured loan, you can borrow money without having to offer anything else in return — except your credit score. If you’re unable to qualify for an unsecured loan, it might be tough to come up with the collateral necessary to secure a loan instead.

Adham Sbeih, CEO and co-founder of Socotra Capital, a real estate lending and investment firm based in Sacramento, California, also says you should look out for prepayment penalties, which are fees charged by the lender if you want to pay the loan off before the term is up. “Make sure you have an exit strategy,” he says, since these loans are not intended to be a permanent solution to cash flow issues. You should have a specific goal for your collateral loan, as well as a plan to pay it off.

What Can You Use as Collateral?

When it comes to the type of assets you can use as collateral, the easier it is to value and turn into cash, the better. So for example, a lender would likely accept a savings account or car as collateral, while your great aunt Sally’s china set might be a tougher sell. Even so, a variety of items can serve as collateral. It all depends on the particular lender’s requirements.

[Read: The Best Home Equity Loans.]

As far as common forms of collateral go, cash in a bank account, such as a savings account or certificate of deposit, usually work well since the value is clear and the funds are readily available. Garvey says you can use a car, house, jewelry or other valuable asset as long as you’re the owner. Life insurance policies with a cash value may be accepted. However, funds in retirement accounts, such as your 401(k) or IRA, are generally not accepted.

In the case of business collateral loans, lenders might accept machinery or other types of equipment, as well as future receivables as collateral. You may have the option, or may be required, to offer up personal assets as collateral, but that can be risky.

Where to Find Collateral Loans

Most financial institutions offer collateral loans. However, the terms and interest rates might vary. If you’re not sure where to start your search, consider these types of lenders:

National banks. Large banks, which tend to offer the widest variety of financial services, are known for their convenience. Borrowing from a national bank can be a good option if you’re already a customer or there aren’t any other convenient options near you.

Community banks. Smaller local banks are more likely to work with local customers. They have to compete with larger banks for business, which means they may offer more competitive terms on deposits and loans.

Credit unions. Another type of community financial institution, credit unions are nonprofit financial co-ops that are owned by their members. Therefore, they are also great places to find collateral loans with lower rates and more attractive terms. To join a credit union, you usually have to live, work, go to school or attend religious services within its field of membership and maintain a savings or share account.

Online lenders. Finally, online banks could provide access to borrowing opportunities that don’t exist locally. Plus, because they operate exclusively via the web and have little overhead, online banks may be able to lend at lower rates. Look for lenders that will let you prequalify to check your potential interest rates and terms before submitting an official application. That way, you can see what your options are without incurring a hard credit inquiry.

Collateral Loan Alternatives

Though it can be easier to borrow money if you secure the loan with collateral, you might not be comfortable risking your assets or you might not have any. If that’s the case, you do have a few other options:

Unsecured personal loan. It’s possible to obtain a personal loan without putting up collateral. This is known as an unsecured loan since you don’t back it with anything of value. Instead, you sign a contract stating that you will pay the loan back according to the terms. And of course, if you don’t, your credit rating will take a hit. The drawback to unsecured loans is the qualification requirements are often stricter, and interest rates can be higher since it’s a riskier loan.

[Read: The Best Personal Loans of 2018.]

Credit-builder loan. If you can’t qualify for a secured or unsecured loan because your credit isn’t good enough, all is not lost. With a credit-builder loan, a financial institution — usually a credit union — will deposit money in a bank account for you and hold it until the end of the loan term. You then pay the institution back for the deposit in installments. Once the term is up and you’ve paid it back, you get the cash. Your credit activity will be reported to the credit bureaus. However, this type of loan doesn’t offer immediate access to funds.

Friend or family member. Finally, you might consider borrowing money from someone you know rather than risking your assets and credit on a loan. Of course, this presents its own challenges, since you can also risk your relationship should you not be able to pay the person back. It’s up to you to determine if borrowing from friends or family is a realistic option.

Ultimately, taking out a collateral loan is a good idea if you are confident in your ability to pay it back. However, if you’re struggling with debt already, adding a collateral loan to your plate could get you in trouble.

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Everything You Need to Know About Collateral Loans originally appeared on usnews.com

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