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The Role of Collateral for Loans

The Role of Collateral for Loans

An individual can apply for a secured loan with a higher amount and a lower interest rate with the help of collateral. Borrowers put up collateral like a valuable item, home, or savings account as their collateral. Generally, there are two types of loans available – secured and unsecured. In this post you'll learn about the role of collateral for loans.

A secured loan is one where borrowers pledge collateral or assets as security against that loan. Suppose the borrower defaults on that loan. In such cases, the lender can seize their collateral and sell it to recover their outstanding balance.

This post helps you understand the ins and outs of collateral in secured loans. So, before understanding what collaterals in loans are, here's how a secured loan works. You can also learn the features of secured loans from the following points:

Features of Secured Loan – How Does It Work?

A secured loan is backed by collateral that the borrower offers. In such loans, the amount doesn't exceed your collateral's value. Your collateral serves as security for your lender to get their outstanding balance in case of default. Moreover, these loans come with reduced interest rates and higher loan amounts. These collateral loans follow a structured repayment plan that includes the following:

  • Interest rate
  • Loan tenure
  • The monthly amount of payment

Any secured loan works on collateral security. Suppose a borrower applies for this loan. As soon as the lender sees the application, they evaluate the creditworthiness and value of the collateral. These two aspects determine the borrower's eligibility.

Now, suppose the value of the collateral for the loan is more than the amount of the loan. Interestingly, the borrower also has a great credit score and a decent monthly income. In such cases, your lender immediately approves your loan and disburses the amount.

A borrower must agree to repay the amount within the due date with interest and other fees. Any repayment failure may result in losing the collateral. Alternatively, the lender or bank may offer you an extended time period to repay the amount.

If you fail, the lender recovers the outstanding balance by selling your collateral. That's how a secured loan works. So, from the above, it is clear that collateral has a major role in secured loans. However, you don't need collateral for personal loans, as they are unsecured loans. So, let's find out what collaterals are from the following point:

An Introduction to Collaterals

Collaterals are a borrower's assets pledged as security for a loan. It can be anything from a home, gold jewellery, or even a car. Its value is greater than the loan amount to offer sufficient security to the lender. The following are the benefits of using collateral for loans:

  • Reduces Risks for Lenders: Accepting collateral helps lenders reduce risks in case of default.
  • Lower Rate of Interest: Collaterals for loans have lower interest rates.
  • A Seamless Approval Process: Collateral can increase loan approval chances, especially for borrowers with bad credit history.
  • A Higher Amount of Loan: Collateral acts as the security, so lenders are more willing to offer a higher loan amount.

Types of Collateral that Secures Your Loan

If you want to opt for secured collateral loans, you can use any of these types of collateral to apply for the loan. Note that collateral requirements may vary from one lender to another. You can get benefits based on the type of collateral you choose.

Real Estate or Loan Against Property

You may use your property or real estate to secure your loan. It's a common practice for business loans and personal loans. After your lender reviews the property, you can get the funds. However, defaulting on your loan may be risky, especially when collateral is involved.

Mutual Funds

You can also use your mutual fund units to get a loan. You may pledge the mutual fund holdings with the NBFC or bank. The amount depends on the scheme and type of mutual fund. Notably, mutual funds' value changes over time.

So, lenders may reduce the LTV, or loan-to-value, on the loan against your mutual fund. Nonetheless, not all banks offer this type of loan. So, you need to visit the bank to understand whether it offers this type of loan before applying. Alternatively, you can check it out on the bank's official website.

Gold

In a land like India, where people celebrate gold as an asset and ritual of gift-giving, they can also use it as collateral. Truth be told, gold loans are secured collateral loans where you borrow money in return for your gold ornaments.

Banks and financial institutes offer a particular tenure. If you are unable to repay the due loan amount, they can extend the period. The prime benefit of using gold as collateral for loans is that it does not require any proof of income or credit assessment. Once you fail to repay it, the lender sells the account to recover the outstanding amount.

Car or Motorcycle

You can use your two-wheeler or four-wheeler vehicle as collateral while applying for a secured loan. In general, lenders can give a whopping 90% of the vehicle's on-road price as the loan amount. Your car will be kept as collateral in the bank during the loan tenure. Someone wishing to apply for the loan must show their monthly income.

Mortgage Loan

You can apply for a mortgage loan by offering immovable assets. That might be your residential or commercial property as collateral. Your lender keeps your assets until you repay the amount. Take LAP or a loan against property, for instance. Such a type of loan can be classified as a mortgage loan. You may use this type of collateral loan to finance your child's wedding or education. Alternatively, you may initiate a business or cover medical expenses with a mortgage loan.

Life Insurance

Collateral assignment of life insurance offers your lender collateral while you apply for the loan. The collateral is the face value of your life insurance policy. So, it can also be used to repay the amount if the applicant dies during the debt period.

So, the above are the prime types of collateral that borrowers usually use for loans.

Tips to follow to Avoid Losing Collateral for Loans?

When it comes to secured loans in India, collateral is essential. It offers lenders security and allows borrowers to obtain higher loan amounts at affordable interest rates. Nonetheless, borrowers must manage their assets sensibly and know the dangers of pledging collateral.

So, do you want to apply for a secured loan while lowering associated risks? It's time to understand the following tips to ensure responsible borrowing and manage collateral accordingly. You can follow these tips to repay your loan carefully.

  • Assess How Much You Can Afford: Defaulting is the prime reason behind losing your valuable asset. So, you need to consider your repayment ability before pledging collateral. As a borrower, you must determine whether you can afford to pay the loan back in a timely manner.
  • Understand Your Loan Term: A borrower needs to understand loan terms before applying for the loan. You need to check the details of the interest rates and additional fees. Also, it is imperative to thoroughly check the conditions under which the lender can seize your collateral in case of default.
  • Never Overextend on Borrowing: A borrower should only borrow the minimum amount that you can repay within the agreed-upon terms. Overextending results in default, which further contributes to collateral loss.
  • Keep an Emergency Fund Aside: You cannot guarantee your future. In case of any unforeseen condition, you can use your emergency fund to cover the expense. So, whether it's a medical emergency or a financial issue, you can cover the expenses using your emergency fund.

Wrapping up

So, do you wish to get a secured loan? It's time to check your credit score and repayment capabilities before using collateral for loan applications. Ensure that you borrow only as much as you can afford. The above things reduce your mental and financial strain and help you plan your finances effectively.

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