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It is permissible for a lender to take something as collateral for a loan. This collateral is held by the lender as a security against failure to repay the loan.

The Prophet (peace be upon him) borrowed a quantity of barley from a Jew and gave him a shield to hold as collateral.

It is permissible for the lender to use the item held in collateral if the borrower permits him to do so. For instance, if the item is a vehicle, the borrower may permit the lender to drive it. If the item is a house, the borrower may agree to let the lender live in it.

However, it is unlawful for use of the item to be stipulated as a condition of the loan. That would make it a loan in lieu of a benefit, which is prohibited in Islamic Law.

Al-Bahûtî writes in the Hanbalî legal encyclopedia Kashshâf al-Qunnâ`:

A condition in a loan contract that provides a benefit to the lender – for instance, allowing the lender to live in the borrower’s house for free or at a reduced rental, or any other compensatory benefit – is impermissible.

This is because a loan is a transaction of kindness and a means of seeking nearness to Allah. If the lender makes a condition for any increase in benefit on his part, it strips the transaction of this meaning.

Stipulating for the lender the right to live in the house at a reduced rental provides an unlawful benefit to the lender. In fact, it is the very “textbook” example that the jurists cite in the legal literature.

And Allah knows best.

Source: Islam Today