What Is Collateral for a Personal Loan and Is It Necessary?

Collateral is any asset you formally pledge to a lender as security for your personal loan. It’s something tangible and valuable, such as a home, car, or money in a bank account.

If you stop making payments and default, the lender can legally reclaim that asset and sell it to recover the remaining balance you owe. The specifics on how this works will depend on your loan terms and state laws.

Not all personal loans require collateral. According to the Consumer Financial Protection Bureau, you may need it if your credit isn’t in decent shape or you have a limited history. If that’s not your case, you might qualify for an unsecured personal loan based on your creditworthiness, income, and debt-to-income ratio (DTI).

Secured personal loans differ from unsecured loans because they require collateral, which can improve approval odds, reduce interest rates, or increase the loan amount for some borrowers. However, secured loans also increase your risk, especially if your cash flow fluctuates, making default more likely.

Note that providing collateral doesn't guarantee approval for a personal loan or the lowest available rate. Lenders still consider your whole financial profile, so consider all options.

Lenders accept a range of assets, but eligibility depends on how easily they can value and liquidate the collateral if you default. Common types include:

• Vehicles: Some lenders accept cars, trucks, and motorcycles as collateral for secured personal loans, but they may set limits on the vehicle’s age, mileage, and condition. When pledging a vehicle, consider GAP insurance if your loan balance could exceed the car's market value.
• Real estate: Home equity loans and HELOCs use your home as collateral. These require appraisals and closing costs, which increase your total borrowing costs, and timelines are longer than most personal loans. Alternatively, some personal loan lenders allow for pledging specific home fixtures rather than the whole property.
• Savings accounts and CDs: Many credit unions offer share-secured loans, which use your bank deposit balance as collateral. You can often borrow 90% to 100% of the account value. These personal loans typically carry low rates and are useful for credit-building, but your funds are frozen until you repay.
• Investment accounts: Securities-backed lines of credit use brokerage assets as collateral. FINRA says rates can be competitive when compared. However, if your portfolio drops in value, the lender may issue a margin call, requiring you to deposit more funds or sell your holdings at a loss.

Here’s what lenders typically won't accept as collateral for personal loans:

• Employer-sponsored retirement plans like 401(k)s, which the Employee Retirement Income Security Act (ERISA) legally protects from most creditors
• Hard-to-value collectibles
• Artwork without a verifiable market
• Assets with unclear ownership or title disputes

Ultimately, if the lender can’t quickly determine the asset’s value and sell it in a default scenario, it’s unlikely to qualify.

Before proceeding with a secured loan, understand all the steps of applying for and managing it. This will help you weigh the costs and risks before you commit.

1. You choose and pledge an eligible asset

Start by identifying an asset you own outright, or with sufficient equity, that a lender will accept as collateral for a personal loan. Lenders will review ownership documentation, the asset's condition, its marketability, and whether it meets their eligibility criteria.

For example, a vehicle typically needs a clear title in your name, while real estate requires proof of ownership and sufficient equity. If you’re pledging a savings account or CD, it must generally be held with or transferred to the lending institution.

2. The lender values the asset

Before approving the loan, the lender must figure out the asset’s value. The resulting amount factors into how much you can borrow.

For vehicles, lenders may use market valuation guides, but for real estate, they often require a licensed appraisal. Valuing savings accounts or CDs is simpler, as lenders can use the balance on file.

3. LTV rules determine your borrowing limit

While the asset value matters, you might not qualify for a large personal loan worth the full amount.

Lenders usually set a maximum loan-to-value (LTV) ratio, which is a comparison of your loan amount to the appraised value of your collateral. For example, if a lender applies a 70% LTV ratio to a vehicle worth $30,000, your maximum personal loan is $21,000.

Note that LTV ratios vary by asset type and lender. A lower LTV generally signals less risk to the lender, increasing your approval chances and possibly leading to lower rates.

4. The lender “perfects” the lien

After approving your loan, the lender "perfects" their security interest, meaning it establishes its claim on your asset. The process can vary based on the type of asset.

For physical assets like vehicles and homes, this usually means the lender's name is added to the title as a lienholder. During the loan term, you're typically required to maintain adequate insurance and provide proof of coverage. For vehicles, lenders often require comprehensive and collision coverage—and possibly GAP insurance if your loan balance could exceed the vehicle's depreciated value.

If you’re pledging bank account funds, expect the lender to put the borrowed amount on hold. However, you might still earn a low interest rate on that locked money.

5. The lender releases the lien upon repayment

In many cases, the lender releases their claim on your asset once you pay the loan in full. For vehicles, they send a lien release or an updated title, while for real estate, they record a deed of reconveyance or a satisfaction of mortgage.

This process typically takes a few days to several weeks, depending on the lender and state. If your records don't update within a reasonable time after payoff, contact the lender directly and follow up with your state's DMV or county recorder if needed.

Share secured personal loans at credit unions usually work differently. Each payment often “unlocks” the frozen funds, allowing you to access that money again relatively quickly. Once you repay in full, the credit union will have fully released your funds.

Using collateral to get a personal loan isn't inherently good or bad. It depends on your credit profile, what you're borrowing for, and how much risk you're willing to accept.

Potential advantages include:

• Higher approval odds for borrowers with limited or imperfect credit.
• Possibility of a lower APR when the asset reduces the lender's risk.
• Access to a larger loan amount tied to the collateral’s value (subject to LTV rules).
• Ability to build credit with a share-secured loan.

Also, consider these potential drawbacks:

• Possible loss of the asset if you can’t repay your loan, which is one of the disadvantages of home equity loans.
• Slower process due to potential appraisals, title work, and insurance verification.
• Added costs like appraisal fees and title insurance, especially for physical assets.
• Possible restrictions on using, selling, or refinancing the asset.
• Risk of owing the difference between a repossessed asset’s sale proceeds and your remaining loan balance.