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Collateral is an asset—often a house or car—that lenders require for certain kinds of loans. Collateral ensures that the borrower will repay a loan as agreed or, if the borrower defaults, provides the lender with a way to recoup its losses. On a mortgage, for instance, the collateral is the home the mortgage was used to buy; on an auto loan, the collateral is the car the buyer drives home from the dealership. The lender can seize the collateral if the borrower isn't making payments, making it a valuable commodity.
What Is Collateral, and How Does It Work?
No one wants to lose their house or car, which means collateral gives the lender more assurance the borrower will repay the loan on time. Lenders consider loans backed by collateral, called secured loans, a safer bet than those that aren't, called unsecured loans. For that reason, secured loans may be easier to get and generally come with lower interest rates.
If you fall behind and can't repay a secured loan, the lender can take the collateral you put up for it. For instance, missed auto loan payments could lead to repossession of your car, which a lender may be able to do without advance warning or court proceedings. Missed mortgage payments could lead to foreclosure, when the lender takes possession of your house.
Your loan contract will make clear how many missed payments lead to loan default, and at what point the lender has the right to take ownership of the collateral.
Types of Collateral
The type of secured loan you're applying for will dictate the collateral you can offer. Below are common consumer loans and collateral that can back them:
- Mortgage: On a mortgage, the home you're buying generally serves as the collateral. That's also the case if you take out a home equity loan or home equity line of credit, both known as second mortgages.
- Auto loan: The car you buy is the collateral on an auto loan.
- Secured credit cards: Getting a secured credit card is a smart credit-building strategy for those with low credit scores or short credit histories. When you apply, you'll pay a deposit that's generally the same as the line of credit you'll receive. That deposit functions as collateral, and you'll lose it if you don't pay off card purchases you make with the card on time.
- Secured loans: Personal loans can be used for all kinds of purposes, like home renovations or consolidating debt. Most are unsecured, meaning they're not backed by collateral. But some lenders offer secured loans, and you can typically use your car, savings account or home as collateral. But remember, you could lose it if you're unable to repay the loan.
Can I Use Collateral to Build Credit?
Collateral can indirectly help you build credit if it backs a secured loan that you repay on time. Payment history is the largest factor in your credit score, which means paying all your bills by their due dates can strengthen your score.
Timely payments on both secured credit cards and secured loans can help you build credit. Taking out a loan solely to improve your credit score, however, may not be wise if you're not absolutely sure you have the flexibility to afford a new monthly payment. And backing a secured loan with an asset like your car as collateral is risky.
Instead, consider a secured credit card with a manageable credit limit, or a credit-builder loan, which is a secured loan generally offered by credit unions for the purpose of boosting credit. On a credit-builder loan, you don't need to put up collateral upfront. Instead, the amount you borrow sits in a savings account, and you'll get it back after you've made all monthly payments on time.
Can I Get a Loan Without Collateral?
You can take out unsecured loans, such as a student loan or personal loan, without collateral. Unsecured credit cards don't require a deposit as collateral like secured cards do. Since there's no asset to seize, unsecured debt generally carries higher interest rates, and it may also be harder to get. You'll likely need strong credit or a cosigner to qualify.
If you don't repay an unsecured loan or pay off credit card debt as required, your credit score will suffer. Your loan may go to collections, and you could be sued for the unpaid debt. While there's no collateral to protect the lender, the benefits of good credit should be enticing enough to encourage you to stay on top of payments.
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