How does loan collateral work? Let's say I need 1000$ but I have 10,000$ to offer as collateral. Why can't I just use the 10k and not take a 1k loan if I need 1k?
Because you might not want to sell what you are putting forth as collateral.
E.g. You have ETH but need BTC for something. You could sell your ETH for BTC, but since you believe ETH will go up in price, you just use it as collateral for a BTC loan. You'll get your ETH back after you do whatever it is you need to do and you return the BTC to the lender.