Why are Car Loans Always Secured with Collateral?
Like many people, you may either have a car already or be about to buy a car, so you might have wondered why are car loans always secured with collateral?
For most people, cars are a basic need, essential for travelling and commuting to work or study. And not everyone has the cash needed to buy a car. We can end up borrowing money to buy a car and car loans are some of the most common loans after credit cards.
Any loan needs to be secured by something that can be sold to compensate for the lender’s loss. This is what is known as a collateral for the loan.
A collateral acts as a guarantee that the borrower (you) will pay back the loan. If you cannot pay back, the collateral is sold to pay back the loan amount and save the lender from losing money.
Car Loan Mechanisms
A car loan is a financial product category that lends people money to buy a car. Banks, credit unions, and other credit service providers issue a certain amount of money to the borrower to purchase a vehicle.
Most people opt to get a car loan because they don’t have the cash for a car. Once the loan is issued, the borrower agrees to pay back the initial amount with interest over the duration of the loan.
When you fill in an application for a car loan, you specify how long you can pay back the loan and how much you can pay. In the case of car loans, the majority of lenders secure the loan with the car.
If approved, you get to fill out paperwork in which you undertake to pay back the loan over the loan period and agree that if you are unable to take it, the bank can repossess the vehicle and sell it off to settle the loan.
Since there is a market for all sorts and varieties of cars, most cars can be sold off. The loan value is recoverable, and most lenders rarely lose money, even in cases of loan default. However, remember that collateral is anything that has value and can be sold for cash.
Collateral for Car Loans
As mentioned earlier, car loans are some of the most common loans that need collateral. Car loans are always secured by the car, and while the simple version is that the vehicle can be sold off to settle the loan, you need to understand why the collateral is required.
Cars are expensive and can be damaged, stolen, and misused. They need to be secured. In addition, unlike other assets, cars don’t appreciate over time. Instead, their value declines with time, even if you don’t use them often. Due to this depreciation of value, car loan issuers need collateral to secure their funds.
Why take Collateral for a Car Loan?
To understand this, put yourself in the lender’s shoes. If you have money to lend, you also need assurance that you will get your money back along with the profit you make from it. This assurance is provided by the collateral. The collateral makes the loan less risky for the lender, and using the car as collateral is convenient as a car is easier to sell than a house or another fixed asset.
The collateral helps protect the loan from the decline in value the car experiences due to daily driving wear and tear, accidents, and even theft.
Other Loans that Need Collateral
While most of us are used to getting credit cards, a collateral-free type of credit, car loans are a typical example of collateral-backed loans. Most other loans are also collateral backed.
For instance, home loans are secured by the home bought with the loan amount. Payday checks are backed by the expected paycheck. Collateral backed loans include loans taken out against life insurance policies, retirement accounts, etc.
Requirements For A Car Loan With Collateral
Don’t assume that if you have a car selected, you are good to go with a car loan. Having a car and a flow of income is not enough to get a car loan approved. As a borrower, you need to have a high credit score, regular monthly income, and low debt levels.
A credit score is a summary of your behavior as a borrower over time. It answers questions like do you make your credit card payments on time? Do you pay your bills promptly? How much of your credit card limit have you used? How high has this gone, and how low? How many of your accounts are maxed out? Have you ever defaulted on a loan or credit card payment? Are all your older loans paid off?
All these things sum up to make your credit score. The higher it is, the better your performance as a borrower is.
Total Debt Level
The total of the borrowings you have at present will add up to the level of debt you have. If this is too high and your pay is just going towards repaying debt, then the chances of you getting another loan are slim. If you have less debt and your repayments take up less than 30% of your paycheck, then your probability of loan approval would be high.
The process of applying for a loan requires submitting documents with all this information. The loan processing officer would assess your profile for viability and, based on the 3-4 criteria above, would approve or reject your loan based on your track record as well as the ability to pay back the loan.
As a borrower, you need to have regular employment for at least 12 months to be eligible for an auto loan. The requirement for employment duration can vary according to debt level, credit score, and overall borrower profile.
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