Though using a collateral loan can be an effective way to borrow money, some risks don’t exist with other types of loans. The major advantages of a collateral loan are:
- You’re more likely to be approved. If you’re having a tough time getting a loan, perhaps due to credit issues or a short credit history, securing a loan with collateral could help reduce your risk as a borrower.
- You might qualify for a larger loan. Similarly, since you are reducing the lender’s risk by offering up collateral, you might qualify to borrow more than you would otherwise.
- It provides short-term liquidity. If all of your money is tied up in assets that aren’t easy to convert into cash, such as a home or valuables, a collateral loan can help you get your hands on money without having to go through the cumbersome process of selling those assets.
On the other hand, there are some disadvantages to collateral loans:
- You can lose the collateral if you don’t pay the loan back. The biggest risk of a collateral loan is you could lose the asset if you fail to repay the loan. It’s especially risky if you secure the loan with a highly valuable asset, such as your home.
- It requires you to have a valuable asset. Another potential issue is that you must have something valuable to offer as collateral in the first place. With an unsecured loan, you can borrow money without offering anything in return – except your credit score. If you’re unable to qualify for an unsecured loan, it might be tough to come up with the collateral necessary to secure a loan instead.
Adham Sbeih, CEO and founding partner of Socotra Capital, a real estate lending and investment firm based in Sacramento, California, also says you should look out for prepayment penalties, which are fees charged by the lender if you want to pay off the loan before the term is up. “Make sure you have an exit strategy,” he says, since these loans are not intended to be a permanent solution to cash flow issues. You should have a specific goal for your collateral loan, as well as a plan to pay it off.