Collateral-Based Loans and Private Money Lending

What is a Collateral-Based Loan?

Collateral-based loans are sometimes called collateralized loans, asset-backed loans, or secured loans. This type of loan is secured by some kind of asset.

An asset used to back a loan is considered to be collateralized by that loan — that is, assigned as collateral for the loan. If the borrower defaults on the loan, the lender can seize the collateralized asset.

The lender may or may not have other recourses in the event of default — that is, they may have the right to go after the borrower’s other assets or even their wages — but they will usually seize the collateral first.

How Does a Collateral-Based Loan Work?

When an asset is used as collateral for a loan, a lien is recorded against it, usually filed with a county clerk or other government registrar as a matter of public record.

The lien is simply the on-paper legal agreement between the borrower and the lender that the asset can be seized through a judicial process (that is, a court proceeding) if the borrower defaults. Law enforcement or third-party enforcement officials may then be deployed to physically claim the asset.

What are some examples? You may have heard of a home being foreclosed upon, or a car being repossessed. This usually means that the home was used as collateral to a mortgage loan; the car collateral to an auto loan. The borrower defaulted, and so the lender claimed the asset according to the terms of the loan.

Do All Loans Require Collateral?

No, not all loans require collateral. Loans without collateral are called unsecured loans. The classic example is a credit card. Banks issue personal credit cards to users based on their personal credit.

If the user defaults on a credit card or other unsecured loan, the lender’s only recourse is to report the default to credit bureaus, which will hurt the user’s credit and make it harder for them to borrow again in the future.

Types of Collateral

The most common assets used as collateral for a loan include:

• Real Estate. Also referred to as a “mortgage loan.” Most homeowners buy with a conventional mortgage secured by the value of the home. Commercial mortgages exist to put liens on apartment complexes, retail properties, office buildings, or industrial property. Real estate can also act as collateral for hard money loans (popular with fix-and-flip investors) or private real estate loans.

• Vehicles. Many people buy cars with an auto loan. They can also cash out or refinance their vehicle value with a title loan or private loan. Other vehicles that can act as collateral for a loan include RVs, boats, and aircraft.

Other assets can act as collateral for a loan, including:

• Fine art. 

• Jewels or jewelry. 

• An investment portfolio or retirement account. 

• Equipment used for a business. 

• Product inventory kept in stock for a business. 

• Accounts receivable on the books of a business. 

• Cash on secured deposit.

Several standardized collateral-based loan programs exist, especially in the real estate and business loan space — for example, Fannie Mae-conforming mortgage loans. Borrowers and their assets must meet stringent criteria to qualify for these loans.

But a private lender and a private borrower can draw up a contract that assigns almost any asset as collateral for a loan, based on whatever terms the parties agree upon.

Pros of Collateralized Loans

• You Can Borrow More. Lenders will often extend larger lump-sum loans or lines of credit when the loan is secured by collateral. They consider the loan to be less risky, because they can seize the asset if the borrower defaults.

• Better Interest Rates. Again, due to the lower perceived risk of the loan, a lender may offer better interest rates. Compare the 10% interest rates on a hard money loan, vs. the 25%+ rates on an unsecured credit card.

• A private lender and a private borrower can use a variety of collateralized assets to put together a loan that works for them. As long as the terms are legal and agreed upon, the lien can be filed and enforced.

• Flexible on Income and Credit. People without the income or the credit score to otherwise justify the loan can get much-needed capital by putting up more collateral. With collateral, a lender may overlook a low FICO score, low income, even negative marks like bankruptcies or foreclosures.

Cons of Collateralized Loans

• Only Available to Borrowers with Assets. If a borrower has no assets to sign over as collateral, they cannot access the benefits of a collateralized loan.

• Risk of Loss to the Borrower. Of course, if the borrower defaults, they risk the asset getting seized. The lender may even have the recourse to go after other assets or even the borrower’s wages.

Loan Amounts

Lenders will rarely lend 100% of the appraised value or market value of the asset. Usually, they will lend a percentage of that value known as the loan-to-value (LTV) ratio or the loan-to-cost (LTC) ratio.

Loan-To-Value (LTV)

The loan-to-value (LTV) ratio is usually expressed as a percentage of the asset’s value that a lender will finance. For example, commercial real estate loans typically cap out at 75%-80% LTV, meaning the buyer has to come up with a 20-25% down payment.

For example, if the deal is for a $500,000 house and the lender wants a maximum 80% LTV, the most the lender will finance is $400,000. The borrower has to come up with the last $100,000 as a down payment.

Loan-To-Cost (LTC)

Hard money lenders, construction lenders, and private lenders may use a loan-to-cost ratio to finance construction or rehab projects. Instead of lending a percentage of the appraised value of the property, they might lend a percentage of the total cost of the project.

Suppose an investor finds a fix-and-flip deal for $300,000 and anticipates $100,000 in rehab costs will bring the home’s value up to $550,000 — a nice potential profit. She finds a hard money lender willing to loan 70% LTC. The home purchase price is only $300,000, but the total project cost is $400,000. If the hard money lender evaluates and approves of the business plan, that lender might loan up to 70% of the total project cost — or $280,000, almost the entire purchase price.

Where to Find Private Money Loans

Private lenders offer asset- and project-based loans to borrowers under a variety of circumstances. With collateral, they may be willing to lend to borrowers with low FICO scores, low income, even bad credit marks like charge-offs, bankruptcies, or foreclosures.

These non-bank institutions often advertise online or attend business and real estate networking events. Borrowers tired of hearing “No” from banks and institutional lenders may find fruitful lending partnerships with private lenders. They can provide much-needed capital to facilitate a variety of business needs.

Private lenders typically issue short-term loans, with the expectation that principal and interest will be repaid within 2-3 years.

How can REID help?

Hard money loans have a bad reputation, in part due to the predatory actions of a few disreputable lenders taking advantage of needy borrowers who didn’t understand what they were signing.

If you are on the market for a collateral-based loan situation from a private lender, don’t rush and don’t fall victim to FOMO or hype. Choose a lending partner worthy of your trust, with the receipts and the reputation to back it up.

REID Lending Partners (RLP) offers fast and fair asset-based loan decisions to give individuals and businesses in the mid-Atlantic region access to affordable, sensible capital solutions.

We have a growing track record of successful lending with the fairest and most transparent loan terms in the business, as well as a reputation for prompt and productive communication with our borrowers and applicants.

Our customer-focused team guides you through the entire process, explaining every step and answering every question, so you can make an informed decision about the best collateral-based loan to suit your needs.

We offer individual private loans ranging in balance from $15,000 to $1,500,000.

Photo by Ushindi Namegabe from Pexels