How Does Collateral Work for Car Loans?

Finance Journalist · 17 October 2018
Buying a car can be an exciting process, from choosing a make and model, to going for a test drive and finally signing the paperwork.

However, for many Aussies a car is a significant purchase, so working out how to finance their new wheels will be an important consideration.

There are a number of ways you can pay for a new or used car, including taking out a car loan. For some car loans, the use of collateral will be an important part of how the loan operates.

So what exactly is collateral, and how does it work when it comes to car loans?

Let’s start from the beginning…

What is a car loan?

This is a loan designed to help customers buy a new or used car. The amount of money borrowed has to be paid back within a certain period of time (called a term), which can typically vary from 12 months to 10 years depending on the agreement, and interest must be paid at either a fixed or variable rate.

What is collateral and how does it work for a car loan?

Collateral is something valuable you agree to put forward as security for repaying your car loan. If you can’t pay the loan back in time you will have to give up this collateral to the lender so they can sell it and recover the debt. The collateral used to secure most car loans is the car itself.

Using your car as collateral
If you fail to repay your car loan, the collateral you have put forward can be taken by the lender and sold to help repay the debt. Source: Nejron Photo (Shutterstock)

Is collateral used for all car loans?

Collateral is only used for secured car loans. It provides the lender with a safety net they can use to get their money back in the event you can’t repay the loan in time. This is what makes the loan secured. For unsecured loans, you don’t need to provide collateral as security.

Secured car loans

To get a secured car loan you must agree to attach collateral as security for the loan in case you fail to repay the money you have borrowed within the agreed timeframe. If the sale of your collateral does not cover the full amount you owe, you will have to pay what is left directly to the lender. Secured loans usually have a lower average interest rate because they carry less risk for the lender.

What collateral could you use for a secured car loan?

Secured car loans will often use the car being purchased as the collateral. However, some other possible forms of collateral could be other vehicles owned by the borrower, home equity, investment accounts, savings accounts or cash. Each form of security can carry its own set of advantages and risks, so it’s important to consider your own circumstances before agreeing to provide any particular form of collateral.

Unsecured car loan

Unsecured car loans do not require any collateral. Instead, the lender will rely on your credit score to approve the loan. This can make these loans a little more complex to apply for, especially for those with poor credit history. Unsecured loans generally have higher interest rates than secured loans.

Who offers car loans?

Car loans may be offered by financial institutions such as banks or credit unions, peer-to-peer (P2P) lenders (as a personal loan), or directly through car dealers.

Before you consider taking out a car loan, it’s important to research and compare the options available to you so you can make the right choice for your needs and budget. Remember to read the Product Disclosure Statement (PDS) of each loan to understand the benefits, risks and fees involved.

The table below displays a snapshot of car loan products on Canstar’s database with links to provider’s websites, sorted by Star Ratings (highest-lowest). These results are based on a loan amount of $20,000 for five years for a new car in the state of NSW.

Cover image source: Stokkete (Shutterstock) 

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