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Why Are Car Loans Secured With Collateral?

Why Are Car Loans Secured With Collateral?; Why are car loans always secured with collateral, and what counts as collateral? Learn all about it from Lantern by SoFi.
Lauren Ward

Lauren Ward

Updated July 21, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
A car loan is one of the most common types of loans that requires collateral. Lenders almost always insist on securing an auto loan with the vehicle itself.If you’re considering an auto loan, it’s important to understand how auto loan collateral works and why providing that collateral makes it so important to stay on top of your payments. 

What Is Collateral?

When learning auto loan terminology, you’ve probably heard of a collateral car loan. Collateral is any asset you use to secure a loan with a lender.  When you use collateral on a loan, you give the lender the right to seize that asset in the event you go into default. What provides collateral to secure a car loan? The car itself is used as collateral.Another example of a loan that requires collateral is a mortgage. In this instance, the house itself is used as the collateral. Other secured loans may accept collateral such as a savings account, an investment account, or a cash deposit.  

Why Are Car Loans Always Secured with Collateral?

A car is an expensive purchase. But, since public transportation is only widespread in large cities, it’s a purchase most adults will need to make. In order to make auto loans less risky for the lender, the would-be borrower will almost always be required to secure the loan with collateral. Luckily, the car itself is typically used as auto loan collateral, rather than the borrower’s savings or house. Another reason why car loans are always secured with collateral is because a vehicle’s value diminishes over time. Paired with the everyday risk inherent in driving and potentially damaging the car, including collateral in an auto loan lowers the risk for the lender that it won’t be able to recoup its money in the case of a default.When a borrower gets behind on his or her payments and goes into default, the lender may repossess the car. It can then be resold to try and get back some of the losses experienced by the lender.

Traditional Loans with Collateral

Beyond car loans, there are many other types of loans that require collateral. A mortgage is secured by the home the loan is used to purchase, and a payday loan is secured by a future paycheck. A credit builder loan is also a type of secured loan for borrowers with below average credit. You use a cash deposit as collateral, then make loan payments that are reported to the credit bureaus. The idea is that making those on-time payments regularly may boost your credit score, but your deposit can be taken if you fall behind. 

Can You Get a Loan with No Collateral?

It is possible to get a loan (including a car loan) with no collateral. The major benefit, of course, is that you protect your personal assets from being seized if you ever go into default (although this doesn’t get rid of your liability for the loan funds).There are a few substantial downsides to consider as well. For one, you’ll likely be approved for a much lower loan amount. One of the reasons why car loans are always secured with collateral is because they’re so expensive. With an unsecured auto loan, you may not be able to finance the full purchase amount. If you use the vehicle as collateral, you may qualify to finance the full amount of your car purchase.A no collateral auto loan will also typically come with higher interest rates. Rather than using the car as collateral, the lender charges more to help make up for  potential losses in the future. It’s also important to remember that even if you don’t use your car as collateral, the lender can still take you to court if your loan goes into default. If you lose the case, the court may order wage garnishment to repay the debt. Or it may allow the lender to place a lien on your house.

What Is an Unsecured Loan?

An unsecured loan is money you can borrow that does not require you to provide any collateral. Examples include unsecured personal loans and student loans, for example. Credit card balances are also a type of unsecured debt. With an unstructured loan, because you’re not putting any financial skin in the game, your creditworthiness is much more important than it is with a secured loan. As we’ve seen, there are still consequences to not making your payments on an unsecured loan, which can result in your being taken to court. Even before it comes to that, expect frequent communication from debt collectors. This may come through aggressive phone calls and letters. 

Secured vs. Unsecured Loans

There are specific benefits and drawbacks when it comes to both secured and unsecured loans. The best choice likely depends on your circumstances.One important factor that differentiates the types of loan has to do with the amount you wish to borrow. Today, the average price of a new car is just over $40,000. Even the cost of a used car averages $25,000. Both are extremely large sums to qualify for an unsecured loan. The cost is largely why car loans are almost always secured with collateral, although some people explore personal loans as well.If you just need a small loan to cover part of the car purchase, then an unsecured loan might make sense. But in most cases, a secured auto loan lets you borrow the amount you need and with lower interest rates. Remember that, if you’re unhappy with your rate or term length, you can always keep an eye on rates to figure out when to refinance. If your credit score improves or rates go down, you could get a better interest rate. Just make sure the cost to refinance makes sense. If the savings are minimal, then auto loan refinancing may not be worth it. 

Requirements for a Secured Loan

Even with a collateral car loan, you’ll need to meet the lender’s requirements in order to be approved. Typically, these might include some or all of the following.
  • Credit Score. This representation of your creditworthiness is based on your credit history as reported by a credit bureau and is a major factor and impacts your interest rate. 
  • Your income and current debts. These are also important considerations. The lender wants to make sure you can comfortably afford your auto loan payments in addition to your other financial commitments. 
  • Employment. You’ll need steady employment for at least 12 months, although the exact time frame can vary from lender to lender. 
  • Other Types of Consistent Income. These might include alimony or disability payments, which may also be sufficient for your application.
  • Residency Standards. If your credit is poor, a lender may set certain residency requirements, such as living in the same home for the last 12 months. 

The Takeaway

Why are car loans usually secured with collateral? The answer is because the loans are much higher and so many people of all credit profiles need this type of loan. But no matter what type of loan you get for your car, lenders view a range of factors to extend an offer.Want to compare loan terms from multiple lenders before making a decision? Use Lantern by SoFi to access top lenders all in one place. 
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website on credit (https://www.consumer.ftc.gov/topics/credit-and-loans)The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC0621111

Frequently Asked Questions

What is collateral?
What is a secured car loan?
What is an unsecured car loan?
What are the requirements for a secured loan?
Is it bad to have a car loan with no collateral?

About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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