Collateral, an asset with value used to secure a loan, improves borrowers’ chances of approval and allows more favorable interest rates by reducing the lender’s risk. Loan agreements have provisions for how collateral may be acquired and sold by the lender if the loan isn’t paid back, protecting the lender’s investment. Real estate is a common form of collateral for securing loans, offering more attractive rates than unsecured loans.
What Are the Types of Collateral?
Real estate, including homes and commercial property, is commonly used as collateral for loans. Lenders often require collateral to protect themselves in case the borrower defaults, lending a percentage of the dollar value of the asset securing the loan. Homeowners can benefit from home equity loans, while businesses can expand through asset-based lending, using real estate and other assets as collateral.
Other assets also may be used as collateral, including automobiles, valuables, equipment, investments, insurance policies, and even cash. Retirement accounts usually aren’t allowable as collateral, but participants in such plans may be able to take out a 401(k) or similar loan against their funds. Lenders are more willing to accept collateral if it’s easy to acquire, value, and sell.
How Do Real Estate-Based Loans Work?
Collateral loans, also known as asset-based loans or real estate secured loans, are common for residential, investment, business, and other real estate types. Real estate property is used as collateral for various types of loans.
First mortgages are the most common and are considered a senior lien on the property, which means the lender has priority should there be claims against the collateral. First mortgage terms are based on the value of the property and the borrower’s income and creditworthiness. Borrowers typically have to make a 20% down payment, but there are options through lenders and government-backed programs to help get home buyers qualified.
Second mortgages, also known as home equity loans, are the second most common type of loan secured by real estate property. Homeowners can tap into the equity they build as property values appreciate and the first mortgage is paid down. They are based on the homeowner’s equity — the greater the equity, the greater the loan amount a lender is willing to grant. Interest rates for second mortgages are lower than unsecured loans; interest on first and second mortgages is typically tax-deductible. Commercial loans may also be secured by home equity.
Home equity lines of credit, known by some as HELOCs, are similar to second mortgages. Borrowers use their HELOC accounts like credit cards, taking out money up to their credit limit as needed. Payment amounts depend on the size of the outstanding loan.
Loans against residences may have lower interest rates but add some degree of risk since they use the home as collateral. Adding to the mortgage also increases monthly payments that can cause budgetary issues.
Commercial loans also may be backed by real property like a business or rental property. Interest rates on commercial loans likely will be higher than home loans and have shorter repayment windows. Commercial loans with real estate collateral will have lower rates than commercial loans using equipment, inventory, or other assets as collateral. Commercial loans require more documentation than loans for residences. Businesses often have to provide additional information like balance sheets, liabilities, income statements, and other documentation.
How Is Collateral Valued?
Lenders won’t offer a loan for the full amount of the collateral pledged to protect their asset interest. Loan-to-value ratios may be as low as 50% for some asset types; for homes, loan-to-value ratios may increase to 80%.
Real property may require an appraisal or tax records to estimate its value for the lender issuing the loan. While vehicles are typically easy to value, other assets like machinery and inventory may take more effort to value. If collateral loses value, borrowers may need to provide more assets for the lender. Borrowers who don’t pay their loans back lose the collateral and are responsible for any additional amount owed to the lender after disposal of the collateral. Lenders aren’t in the business of selling real estate or other property but will do so to recoup their money if needed.
What Is Unsecured Borrowing?
Borrowing without putting up an asset is common. Unsecured loans provide less risk for the borrower and more risk for the lender. Interest rates will be higher and will be based on credit score and other factors. Since there is no collateral, lenders have less ability to recover losses; they may still seek a judgment or garnishment of the borrower’s wages. Borrowers’ credit rating will also take a hit if payments are late or the loan defaults.
While unsecured loans for individuals may be approved by showing proof of income and creditworthiness, unsecured business loans go a step farther. They require businesses to prove sufficient cash flow in addition to creditworthiness. Interest rates are usually higher than secured loans, but such loans could satisfy short-term needs.
Several unsecured loan types are available to commercial and non-commercial borrowers:
- Signature loans are available from banks, credit unions, and other lenders.
- Banks typically offer lower interest rates to commercial and non-commercial borrowers but require higher credit scores.
- Alternative loans are available to businesses and individuals with lower credit ratings, but interest rates will be higher.
- Merchant cash advances and invoice financing will offer businesses loans against future bank deposits and unpaid invoices that are 30 to 90 days out.
- Personal lines of credit are extended as a specified line of credit.
- Credit cards can be used as loans and offer convenience and flexibility, but interest rates may be steep.
- Peer-to-peer loans are borrowed from individuals instead of banks or other traditional lenders. Such transactions are typically facilitated by websites and are similar to installment loans.
- Student loans are unsecured and, as the name suggests, are only available for students. They offer low and often subsidized interest rates and repayment flexibility and are designated for tuition and school-related expenses.
Taking out a loan with real estate as collateral gives borrowers lower interest rates and easier approval while protecting lenders from losses should the borrower fail to make payments. Real estate property provides better interest rates than other forms of collateral like vehicles and equipment. Borrowers need to weigh the benefits and risks of various types of collateral-backed and unsecured loan options to find out which type is the best fit. For more information on collateral loans, contact the team at Titan Funding today.