What Are Collateral Loans and How Do They Work?

Peer-to-Peer Lending (P2P)

Peer-to-peer (P2P) lending—also known as social lending or crowdlending—is a method of financing that enables individuals to borrow from and lend money to each other directly, without an institutional intermediary, like a bank or broker. While it removes the middleman from the process, it also involves more time, effort, and risk than going through an official financial institution.

With peer-to-peer lending, borrowers receive financing from individual investors who are willing to lend their own money for an agreed interest rate. The two link up via a peer-to-peer online platform. Borrowers display their profiles on these sites, where investors can assess them to determine whether they would want to risk extending a loan to that person.

Advantages and Disadvantages of Borrowing Through Peer-to-Peer Lending

A borrower might receive the full amount they're asking for or only a portion of it. In the case of the latter, the remaining portion of the loan may be funded by one or more investors in the peer lending marketplace. It's quite typical for a loan to have multiple sources, with monthly repayments being made to each of the individual sources.

For lenders, the loans generate income in the form of interest, which can often exceed the rates that can be earned through other vehicles, such as savings accounts and CDs. In addition, the monthly interest payments a lender receives may even earn a higher return than a stock market investment. For borrowers, P2P loans represent an alternative source of financing—especially useful if they are unable to get approval from standard financial intermediaries. They often receive a more favorable interest rate or terms on the loan than from conventional sources too.

Still, any consumer considering using a peer-to-peer lending site should check the fees on transactions. Like banks, the sites may charge loan origination fees, late fees, and bounced-payment fees.

Pros and Cons of P2P Lending Pros Borrowers might be able to get a P2P loan even if they do not qualify for other sources of credit. Loan interest may be lower than traditional lenders. Cons P2P lending sites may have complex fee structures that borrowers need to read carefully. Borrowers may end up owing money to multiple lenders rather than a single creditor.

How to calculate your debt-to-income (DTI)

Learn how DTI is calculated, see our standards for DTI ratios, and find out how you may improve your DTI.

Understand your debt-to-income ratio

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Different Types of Bank Loans

There are a variety of personal loans available through banks. If you are buying a car, you will apply for an auto loans. If you need money for other reasons, you might apply for a personal line of credit. If you want to access the equity in your home, you might take out a line of credit against your home, called a home equity loan. These all tend to be secured loans. Banks might also offer unsecured personal loans. Credit unions typically offer the same types of loans, sometimes at lower rates.

Related: 10 Best Credit Unions for Car Loans

What Are the Types of Borrowing?

Borrowing exists in many forms and can be classified in different ways. Most loans are either secured, meaning they're backed by an asset, which is forfeit to the lender if the borrower defaults; or unsecured, meaning they have no collateral.

Common types of borrowing include:

  • Mortgages
  • Personal loans
  • Credit card advances
  • Title loans
  • Payday loans
  • Bank overdrafts

What your credit score means

Your credit score reflects how well you’ve managed your credit. The 3-digit score, sometimes referred to as a FICO® Score, typically ranges from 300-850. Each of the 3 credit reporting agencies use different scoring systems, so the score you receive from each agency may differ. To understand how scores may vary, see how to understand credit scores.

Wells Fargo credit score standards

760+, Excellent

You generally qualify for the best rates, depending on debt-to-income (DTI) ratio and collateral value.

700-759, Good

You typically qualify for credit, depending on DTI and collateral value, but may not get the best rates.

621-699, Fair

You may have more difficulty obtaining credit, and will likely pay higher rates for it.

620 & below, Poor

You may have difficulty obtaining unsecured credit.

No credit score

You may not have built up enough credit to calculate a score, or your credit has been inactive for some time.

How do collateral loans work?

With a collateral loan, you can expect to receive more attractive loan terms than with an unsecured loan. This might include a lower interest rate, larger loan amount or a longer loan term.

Before a lender approves you for a collateral loan, they will take the time to determine how much your collateral is worth. To do this, they’ll consider the fair market value of what you own, or in the case of a mortgage, the appraised value of your home. Then they’ll determine the size of your loan by offering you a percentage of what your collateral is worth. With a mortgage, for example, a lender will consider factors like the potential resale value of the home you’re considering, and the surrounding neighborhood.

With a mortgage, the value of your collateral is directly reflected in the loan-to-value ratio (LTV) a lender will assign to your loan. In general, the higher your LTV, the more you can expect to pay in interest costs and closing costs. You’ll also need a larger down payment. If your LTV is 80%, you’ll know your lender is willing to lend you a substantial amount of money, but you’ll need to cover the remaining 20% out of pocket.

Qualifying for a Loan

To get a loan you’ll have to qualify. Lenders only make loans when they believe they’ll be repaid. There are a few factors that lenders use to determine whether you are eligible for a loan or not.

Your credit is a key factor in helping you qualify since it shows how you’ve used loans in the past. If you have a higher credit score, then you’re more likely to get a loan at a reasonable interest rate.

You'll likely also need to show that you have enough income to repay the loan. Lenders will often look at your debt-to-income ratio—the amount of money you have borrowed compared to the amount you earn.

If you don’t have strong credit, or if you’re borrowing a lot of money, you may also have to secure the loan with collateral—otherwise known as a secured loan. This allows the lender to take something and sell it if you’re unable to repay the loan. You might even need to have someone with good credit co-sign on the loan, which means they take responsibility to pay it if you can’t.

What happens if you don’t repay your collateral loan?

Depending on the lender, your collateral loan might be considered to be in default just 30 days after you miss a payment. However, most lenders allow for a grace period after a borrower has  missed a payment. Your loan might be considered delinquent at that time, but most likely you’ll be able to work with your lender to come up with an acceptable payment plan before your loan actually goes into default.

If your account continues to be delinquent, you might be in danger of losing your asset, depending on the lender, the type of loan and the state where you live. Read the fine print in your contract to understand your loan’s payment obligations and check your state’s laws.

For example, depending on the lender, repossession of a car might occur within 90 to 120 days after a borrower’s last payment, and a lender may not necessarily have to go to court. If you’ve defaulted on your mortgage, the foreclosure process will usually begin once you are 120 days late, although in some states lenders may have to take you to court first.

How Does a Loan Payment Work?

Loans are paid in pre-defined increments over the term defined. Say you make monthly payments towards your car loan, each payment will cover the interest due and some amount of the principal. The more money you can apply to a payment means more principal you knock out in each payment. Paying down your principal and wrapping up a loan quickly means you can save money you would have spent on interest payments.

To learn more about features Earnest offers to clients repaying loans with us, please see ‘Repaying Student Loans with Earnest: 7 Amazing Things You Can Do as a Client‘. 

How to Apply for a Personal Loan

Whenever you ask a lender for any kind of credit, you’ll have to go through the application process. However, before you submit a personal loan application, it’s important to review your credit report and your credit score, so you’ll understand what lenders might see when they pull your credit report and scores. Remember, checking your own credit report never affects your credit scores, so you can check as often as you need.

Once you’ve reviewed your credit and taken any necessary steps based on what you see, you can apply for a personal loan through any financial institution such as a bank, credit union or online lender. Every lender you apply to will check your credit report and scores.

Lenders will usually consider your credit scores when reviewing your application, and a higher score generally qualifies you for better interest rates and loan terms on any loans you seek. The lender will also likely look at your debt-to-income ratio (DTI), a number that compares the total amount you owe every month with the total amount you earn. To find your DTI, tally up your recurring monthly debt (including credit cards, mortgage, auto loan, student loan, etc.), and divide by your total gross monthly income (what you earn before taxes, withholdings and expenses). You’ll get a decimal result that you convert into a percentage to arrive at your DTI. Lenders like to see DTIs under 36%, but many may provide loans to borrowers with higher ratios.

How Does Your Credit History Impact Your Interest Rate?

Before you can take out a loan, secured on unsecured, you first have to apply. Financial institutions and lenders will do a soft credit pull first to confirm you meet the minimum requirements to apply. If you move forward with an application, the lender will do a hard credit check to review your credit history.

If you want to review your own credit history you can request a credit report from one of the major credit agencies; Experian, Transunion, and Equifax. You can request a free report each year from each lender, so you can see what a lender will be reviewing.

Your creditworthiness will play a role in the interest rate offered. If you have a good credit score, the lender will have more peace of mind that you will repay your loan, and offer you a lower interest rate or maybe a larger amount of money. If you have a lower credit score you might want to build your score back up before submitting a loan application to see a better loan offer.

Read more: How to Build Credit in 6 Easy Steps

5. Impact on your credit scores

When you apply for a loan, the lender will pull your credit as part of the application process. This is known as a hard inquiry and will usually lower your credit scores by a few points.

Generally speaking, hard inquiries stay on your credit reports for about two years.

When you’re shopping around for the best rates, some lenders that you already have an account with will review your credit. This is known as a soft inquiry and doesn’t affect your credit scores.

Consider checking your rates with lenders that will do soft pulls, which won’t impact your scores.

Alternatives to bank loans

Bank loans are not your only option. You can work with alternative lenders to secure the funding you need. Alternative lenders are an option to consider if your business doesn’t qualify for a traditional loan. Here are two alternative lending options to consider:

  • Online loans: Online lenders are normally more flexible with loan qualifications, and the turnaround time is faster, but the rates may be higher than traditional loans. Lendio is one such online lender. You can submit an application through their secure interface. 
  • Microloans:  Microloans offer a small amount of money to help you cover certain costs within your company. Microloans usually have a relatively low interest rate. The disadvantages of microloans include a shorter time frame to pay back the loan, and some lenders require that the money from the microloan be spent on specific expenses like equipment purchases.

How do you pay back a loan?

Your loan agreement will have information about how to repay your loan, and the exact setup depends on what type of loan and terms you have. Generally, you'll make a payment by a scheduled due date every month. You can typically set it up as an automatic draft or mail a check to your lender each month. If your loan allows it, you can also make extra payments toward principal to pay it off sooner.

Your Credit Score Dictates the Cost to Borrow

When weighing whether a personal loan makes sense, you have to consider your credit score. It’s a number ranging from 300 to 850 that rates the likelihood of you paying back your debt based on your financial history and other factors. Most lenders require a credit score of 660 for a personal loan. With credit scores lower than that, the interest rate tends to be too high to make a person loan a viable borrowing option. A credit score of 800 and above will get you the lowest interest rate available for your loan.

In determining your credit score a lot of factors are taken into account. Some factors carry more weight than others. For example, 35% of a FICO score (the kind used by 90% of the lenders in the country) is based on your payment history. (More FICO  facts are here.) Lenders want to be sure you can handle loans responsibly and will look at your past behavior to get an idea of how responsible you’ll be in the future. Lots of late or missed payments are a big red flag. In order to keep that portion of your score high, make all your payments on time.

Coming in second is the amount of credit card debt outstanding, relative to your credit limits. That accounts for 30% of your credit score and is known in the industry as the credit utilization ratio. It looks at the amount of credit you have and how much is available. The lower that ratio the better. (For more, see The 60 Second Guide To Credit Utilization.) The length of your credit history, the type of credit you have and the number of new credit applications you have recently filled out are the other factors that determine your credit score.

Outside of your credit score, lenders look at your income, work history,  liquid assets and the amount of total debt you have. They want to know that you can afford to pay the loan back. The higher your income and assets and the lower your other debt, the better you look in their eyes.

Having a good credit score when applying for a personal loan is important. It not only determines if you’ll get approved but how much interest you’ll pay over the life of the loan.  According to ValuePenguin, a borrower with a credit score between 720 and 850 can expect to pay 10.3% to 12.5% on a personal loan. That increases to between 13.5% and 15.5% for borrowers with credit scores from 680 to 719 and 17.8% to 19.9% for those in the 640 to 679 range. Under 640 and it will be too cost prohibitive even if you can get approved. Interest rates at that level range from 28.5% to 32%.

Our methodology

To determine which personal loans are the best, Select analyzed dozens of U.S. personal loans offered by both online and brick-and-mortar banks, including large credit unions, that come with no origination or signup fees, fixed-rate APRs and flexible loan amounts and terms to suit an array of financing needs.

When narrowing down and ranking the best personal loans, we focused on the following features:

  • No origination or signup fee: None of the lenders on our best-of list charge borrowers an upfront fee for processing your loan.
  • Fixed-rate APR: Variable rates can go up and down over the lifetime of your loan. With a fixed rate APR, you lock in an interest rate for the duration of the loan's term, which means your monthly payment won't vary, making your budget easier to plan.
  • Flexible minimum and maximum loan amounts/terms: Each lender provides a variety of financing options that you can customize based on your monthly budget and how long you need to pay back your loan.
  • No early payoff penalties: The lenders on our list do not charge borrowers for paying off loans early.
  • Streamlined application process: We considered whether lenders offered same-day approval decisions and a fast online application process. 
  • Customer support: Every loan on our list provides customer service available via telephone, email or secure online messaging. We also opted for lenders with an online resource hub or advice center to help you educate yourself about the personal loan process and your finances.
  • Fund disbursement: The loans on our list deliver funds promptly through either electronic wire transfer to your checking account or in the form of a paper check. Some lenders (which we noted) offer the ability to pay your creditors directly.
  • Autopay discounts: We noted the lenders that reward you for enrolling in autopay by lowering your APR by 0.25% to 0.5%.
  • Creditor payment limits and loan sizes: The above lenders provide loans in an array of sizes, from $500 to $100,000. Each lender advertises its respective payment limits and loan sizes, and completing a preapproval process can give you an idea of what your interest rate and monthly payment would be for such an amount.

After reviewing the above features, we sorted our recommendations by best for overall financing needs, debt consolidation and refinancing, small loans and next-day funding.

Note that the rates and fee structures advertised for personal loans are subject to fluctuate in accordance with the Fed rate. However, once you accept your loan agreement, a fixed-rate APR will guarantee interest rate and monthly payment will remain consistent throughout the entire term of the loan. Your APR, monthly payment and loan amount depend on your credit history and creditworthiness. To take out a loan, lenders will conduct a hard credit inquiry and request a full application, which could require proof of income, identity verification, proof of address and more. 

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.

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