Collateral can help you get approved for a loan when credit scores or income fall short. It gives lenders something to claim if you stop making payments—like your car, home, or savings.
Putting up collateral often leads to better rates and bigger loan offers. But there’s a real risk: if you default, you could lose that asset. Before you agree to a secured loan, make sure the tradeoff works in your favor.
How does collateral work?
Collateral works as a form of assurance for lenders, providing them with a valuable asset they can seize if a borrower defaults on their loan. It’s a safety net, reducing the risk for the financial institution and often enabling borrowers to qualify for loans they otherwise might not get.
When applying for a secured loan, like a home equity or auto loan, borrowers pledge a specific asset to the lender if they can’t make monthly payments. This asset, such as real estate or a car, serves as collateral.
Secured vs. Unsecured Loans: What’s the difference?
Secured loans are backed by collateral—something the lender can take if you don’t repay. Mortgages are backed by the home itself. Auto loans are backed by the car. Because the lender has something to recover, these loans often come with lower interest rates.
Unsecured loans don’t require collateral. Approval is based on your credit history, income, and overall financial profile. Personal loans and credit cards fall into this category, but they usually come with higher rates and stricter approval criteria.
Why do lenders require collateral?
Collateral gives lenders a backup plan. If you stop making payments, they can take the asset and sell it to recover their money. This lowers the risk for the lender—and in turn, can lower costs for you.
Because the loan is backed by something of value, lenders are more likely to offer lower interest rates, higher limits, and more flexible terms. That’s why secured loans can be a smart option if you’re borrowing a larger amount or trying to keep payments manageable.
How Lenders Decide What Your Collateral Is Worth
Lenders evaluate collateral based on how much it’s likely to sell for if they ever need to take it. They’ll look at its current market value, age, condition, and how easy it would be to sell.
For home equity loans, they calculate how much equity you have—the portion of your home you’ve already paid off. With car loans, they estimate the resale value of the vehicle using trusted pricing sources. The stronger the collateral, the more favorable your loan terms may be.
What happens if you default on a secured loan?
If you fall behind on payments, the lender has the legal right to take the asset you used as collateral. That’s called a security interest. Most lenders won’t move to seize it right away—they may try to adjust your payment plan or offer other solutions first.
But if you stop paying and the lender takes the collateral, it can damage your credit history and make it harder to qualify for loans in the future. You’ll also lose the asset, which could have a lasting financial impact.
Pros & Cons of Using Collateral
Offering collateral can help you get approved and save money—but it also adds risk. Here’s a quick look at the tradeoffs to consider before moving forward:
Pros
- Lower interest rates: Lenders take on less risk, which often means better pricing for you.
- Higher borrowing limits: Collateral-backed loans typically allow for larger loan amounts.
- Easier approval: If your credit score isn’t strong, offering collateral may improve your chances.
- More flexibility: Secured loans can sometimes offer longer terms or more repayment options.
Cons
- Risk of asset loss: If you default, you could lose your home, car, or other property.
- Tied-up equity: You can’t use or sell the asset freely while it’s tied to a loan.
- Slower process: Some secured loans require appraisals or extra paperwork to verify the value.
- Ongoing maintenance: If your collateral loses value—like a car—your loan terms won’t adjust to match.
Collateral-backed loans can work in your favor, but they come with real risks. Make sure the benefits outweigh what you’re putting on the line.
Examples of Collateral in Action
Let’s look at how collateral works in real life.
A borrower wants to buy a car but doesn’t have the cash upfront. They apply for an auto loan, and the car itself secures the loan. If they don’t make payments, the lender can repossess the vehicle.
In another case, a homeowner needs capital to launch a business. They take out a home equity loan, putting their house on the line. The funds are accessible, but missing payments could lead to foreclosure.
In both examples, collateral makes the loan possible—but repayment is critical.
Smart Ways to Use Collateral
Here are a few tips to use collateral responsibly:
- Know the risk: Don’t offer up an asset unless you’re confident you can repay the loan.
- Weigh your options: Secured loans may offer better rates, but unsecured loans remove the risk of losing property.
- Take care of your asset: The condition of your collateral affects its value. Keep it in good shape, especially if it’s a car or piece of equipment.
- Have a backup plan: If money gets tight, consider refinancing or selling the asset before default becomes a threat.
Collateral Myths That Can Cost You
Two common myths can trip up borrowers. First, it’s not just physical items like homes or cars that can be used as collateral. Some lenders accept savings accounts, investments, or even future business revenue.
Second, one missed payment doesn’t automatically mean you’ll lose your asset. Lenders often try to work with borrowers before taking legal steps—but repeated missed payments can lead to seizure.
Final Thoughts
Collateral can help you borrow more and pay less—but it puts your property on the line. Whether you’re using a home, car, or cash account, the key is to borrow within your means and protect what you own.
Before you sign, run the numbers. Make sure the loan works for your budget, not just today but long term. A smart decision now can save you from bigger problems later.
Frequently Asked Questions
Can I get my collateral back before the loan is fully paid off?
In most cases, no. The lender holds the collateral until the loan is fully repaid. Once the loan is paid off, the lender releases their claim, and you regain full control of the asset.
What happens if the value of my collateral drops during the loan?
If your collateral loses value, the loan terms don’t automatically change—but it can become a problem if you default. In some cases, the lender may require you to provide additional collateral or pay down part of the loan.
Can a savings account be used as collateral?
Yes, a savings account or certificate of deposit can be used as collateral for certain types of secured loans, such as cash-secured loans or secured credit cards.
Can I use the same asset as collateral for more than one loan?
Generally, no. Most lenders won’t accept collateral that’s already tied to another loan. An asset typically can’t secure more than one loan at the same time without special approval or a second lien agreement.
Does collateral affect my credit score?
Collateral itself doesn’t impact your credit score, but your payment history on a secured loan does. Making on-time payments can help your credit, while missed payments or default can cause significant damage.
