If you don’t have the cash to buy an expensive item like a car, boat or house, you can still make your purchase by taking out a collateral loan. Collateral loans are available from financial institutions such as banks and credit unions. To qualify, you must have a high enough credit score and income level to meet the lender’s loan requirements. Since interest rates for the same loan can vary from one financial institution to another, it pays to shop around to make sure you get the best possible loan.
What Makes a Loan Collateralized
A loan that is secured by some type of tangible asset is known as a collateral loan. Collateral loans give your lender the right to repossess, or take back, the asset and resell it to recoup the money loaned to you. For example, if your financial institution loans you the money to buy a car, the car is used as collateral to secure the loan. Almost any type of asset, from homes to airplanes, cars, boats and jewelry, can be used to collateralize a loan.
The interest rates for collateral loans are generally lower than for unsecured loans. The lender has the right to repossess the asset if you stop making payments. This right of repossession makes a collateral loan far less risky than an unsecured loan, such as a credit card. The lender’s lowered risk translates into lower interest rates. It’s also easier for someone with poor credit to qualify for a collateral loan since the asset secures the loan. Collateral loans can have fixed interest or a variable interest rate that fluctuates over time.
Your collateral loan duration depends on what you’re buying and your income. The rule of thumb is that the smaller the loan, the higher the monthly payment, since you have a shorter amount of time to repay the money. For example, you can have from three to seven years to repay a car loan but 15 to 30 years to repay a mortgage loan. The longer you take to repay your loan, the more interest you pay over the life of the loan.
Even with a collateral loan, your credit score and income limits the amount of money a lender will loan you. In addition, federal regulations can also limit your loan amount. For example, if you’re applying for a home loan through the Federal Housing Administration, your monthly mortgage payment cannot exceed 29 percent of your gross income. Regardless of what you are buying with your collateral loan, any amount you bring to the table lowers the amount of money you need to borrow and, ultimately, your monthly repayment amount.
Based in St. Petersburg, Fla., Karen Rogers covers the financial markets for several online publications. She received a bachelor's degree in business administration from the University of South Florida.