What is a Collateral Loan? Definition, Types & How It Works

Financial institutions generally provide two primary types of loans — secured and unsecured, with the main difference being the requirement of collateral. Loans backed by an asset are termed secured or collateral loans, while those provided without any security are called unsecured loans. Let’s explore collateral loan meaning and its types.

Table of Content

• Understanding Collateral Loans
• Types of Collateral Loans
• Benefits of Collateral Loan

Understanding Collateral Loans

A secured loan, commonly called a collateral loan, involves a borrower providing an asset—like a home, automobile, or other high-value possessions—as a guarantee to the lender. The lender has legal rights to seize the pledged asset when there is a default in repayment to recover the outstanding loan amount. Since the lender’s risk is reduced due to the presence of collateral, these loans are generally easier to obtain compared to unsecured loans like personal loans.

To get a collateral loan, the borrower must provide comprehensive details about the asset being pledged, including its ownership, market value, and condition. The asset offered as collateral is typically subjected to a detailed assessment or physical inspection by the lender. Based on this assessment, the eligible loan amount is determined. After the borrower accepts the terms and completes the loan agreement, the approved amount is released by the lender.

Types of Collateral Loans

Now that you’re familiar with what a collateral loan is, it’s equally important to understand the different types of collateral available. Here’s a breakdown of some common forms of collateral-backed loans:

1. Loan Against Property

This type of loan is secured by immovable assets such as residential homes, commercial buildings, industrial units, or farmland. A loan secured by collateral property generally offers an extended repayment period, often up to 15 years. Based on your eligibility and the property’s market value, you may qualify for up to 65% financing of its current worth. The borrowed amount may be allocated toward diverse lawful purposes, including personal expenses or commercial ventures.

2. Gold Loans

Gold serves not just as jewellery or investment but also as a viable loan security. When you opt for a gold loan, the lender assesses the purity and weight of the gold (usually between 18 and 24 karats) before sanctioning the loan. One limitation of gold loans is that if the market price of gold drops significantly, you may be asked to pay additional margin money. Also, the loan amount might differ from what you expect, depending on market fluctuations.

Suggested Read: A Complete Guide About Gold Loan Process and Eligibility

3. Vehicle Loans

Vehicle Loan covers both two-wheeler and four-wheeler loan options, catering to a variety of automobile purchases. Two-wheeler loans typically come with a repayment period of up to 48 months and can be used to purchase anything from basic scooters to premium bikes. Car loans, also referred to as car collateral loans, can have a tenure of up to 7 years with good funding amounts. The vehicle remains under the lender’s ownership until the loan is fully repaid, and any default on EMIs may result in repossession.

Suggested Read: Impact of Your Credit Score on Vehicle Loan Rates

4. Loans Backed by Investments

Another way to obtain funds is by pledging your investment assets. Financial institutions often accept low-risk, stable instruments such as fixed deposits, government bonds, or cash-value life insurance policies as collateral. Since these instruments are not market-linked, they’re usually preferred for secured lending.

5. Equipment Financing

Business owners can obtain loans by using machinery or equipment as security to back their loan applications. This type of funding, known as equipment finance, is especially useful in sectors like construction and manufacturing. Equipment like cranes, bulldozers, tippers, or RMC plants can be used as security to access capital for business operations or expansion.

Benefits of Collateral Loan

Collateral loans come with a range of benefits that make them a preferred choice for borrowers needing substantial funding. Here are some of the key advantages:

Access to Higher Loan Amounts

The amount of money sanctioned through these loans depends on the current market value of the assets used as collateral. For example, if you pledge a residential property valued at INR 80 lakhs, and the lender offers a loan-to-value (LTV) ratio of 65%, you could be eligible for a loan of up to INR 52 lakhs—provided you meet the lender’s eligibility criteria. Very few financial products offer such high funding options.

Lower Interest Rates

Collateral-backed loans usually come with more competitive interest rates compared to unsecured loans. This is because the lender’s risk is significantly reduced due to the presence of security. For instance, properties tend to appreciate, making them safer for lenders. In the event of a default, the lender can recover the outstanding dues by auctioning the asset. However, not all assets behave the same—vehicles, for example, depreciate over time, and investment-linked instruments may fluctuate in value due to market conditions, which can affect the interest rates offered.

Flexible End-Use

One of the standout features of collateral loans, especially those secured against property or gold, is their versatility. Borrowers are typically not restricted in how they use the funds, provided the usage is legitimate. Whether it’s for business expansion, higher education, home renovation, or medical expenses, the funds can be directed wherever they’re needed most. And due to the high loan amount, they can even be used to fulfil multiple financial requirements simultaneously.

While collateral loans are generally easier to obtain than unsecured options and tend to offer lower interest rates, it’s crucial to keep in mind that your asset is at risk. Whether you’re considering a home loan or any other secured borrowing option, it’s essential to evaluate your financial situation and repayment capability before proceeding.