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Collateral for Loans – The Pros and Cons to Know

When a bank provides a loan to a borrower, they sometimes request collateral.  Collateral is an asset (typically property or perhaps an automobile) that the borrower owns and offers up as surety to the lender that they will repay.  If the borrower defaults on the loan, the lender has rights to take ownership of that asset.

Collateral FAQ

Why do banks require collateral?

Banks may require collateral if the borrower has a poor FICO credit score, if the loan amount is large or if there is risk factors that may impact the borrower.  Business loans, mortgages, auto loans and loans for other large assets (like a fancy yacht) sometimes require this backing.

How much collateral is needed to obtain a secured loan?

If required for your loan, banks typically require collateral worth more than the loan value.  Plan on an 80% loan to asset ratio. A $100,000 piece of property that you own may garner you an $80,000 loan.  The ratio is important – if you offer up a vehicle valued at $20,000 for a $2500 loan, you will have a greater chance of getting approval than if you are requesting an $18,000 loan.

What if I don’t repay my loan? Can the bank take my collateral without permission?

By entering into an agreement with a bank that includes collateral in your loan terms, you have agreed to allow the bank to take over ownership of that asset.  So don’t default on your loan!  When putting up collateral, be sure to fully understand the bank’s rights and what their process is in the event you default.

What are the benefits of a secured loan?

Secured loans typically have lower interest rates than unsecured.  A secured loan may be your only option if the bank deems you not credit worthy or the loan is extra risky.

What are the disadvantages to putting up collateral?

Besides the obvious disadvantage of potentially having to hand over your property, you can not sell it either.  Let’s say you own a rental property and then want to sell it to pay for unexpected medical bills. You will not be able to sell until your loan is paid off.  Never put up assets as collateral if you believe you may need to sell it in the near future.

Is collateral recommended for loans between friends and family?

Loans agreed upon between friends and family are typically the most flexible and commonly don’t require collateral.  There are advantageous to offering collateral though if the borrower is requesting a large loan to start a business.  This provides greater assurance to the lender on the borrower’s promise to pay.  (This is especially helpful if you have defaulted on loans with that party prior!)  If a loan between friends and family is made, it is always recommended that the loan is documented in writing between the parties, including any terms involving collateral.

If you can't qualify for a loan and don't have any collateral, try hitting up a friend or a family member.

Learn how to successfully request a loan from friends or family as well as assure a good outcome for both parties.  Hint: collateral is rarely required!

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