diff --git a/src/Internal/BalanceTx/BalanceTx.purs b/src/Internal/BalanceTx/BalanceTx.purs
index fec897cef..01659630a 100644
--- a/src/Internal/BalanceTx/BalanceTx.purs
+++ b/src/Internal/BalanceTx/BalanceTx.purs
@@ -39,8 +39,10 @@ import Cardano.Types
   , _witnessSet
   )
 import Cardano.Types.Address (Address)
+import Cardano.Types.Address (getPaymentCredential) as Address
 import Cardano.Types.BigNum as BigNum
 import Cardano.Types.Coin as Coin
+import Cardano.Types.Credential (asPubKeyHash) as Credential
 import Cardano.Types.OutputDatum (OutputDatum(OutputDatum))
 import Cardano.Types.TransactionBody (_collateral, _votingProposals)
 import Cardano.Types.TransactionInput (TransactionInput)
@@ -152,6 +154,7 @@ import Data.Map (Map)
 import Data.Map
   ( empty
   , filter
+  , filterKeys
   , insert
   , isEmpty
   , lookup
@@ -292,7 +295,14 @@ setTransactionCollateral changeAddr availableUtxos transaction = do
           "Filtered collateral UTxOs do not cover the minimum required \
           \collateral, reselecting collateral using CTL algorithm."
           (pprintUtxoMap (TransactionUnspentOutput.toUtxoMap spendableUtxos))
-        selectCollateral availableUtxos
+        let
+          isPkhUtxo txOut = isJust do
+            cred <- Address.getPaymentCredential $ (unwrap txOut).address
+            Credential.asPubKeyHash $ unwrap cred
+        availableUtxos' <- liftContract $
+          Map.filter isPkhUtxo <<< Map.filterKeys isSpendable <$>
+            filterLockedUtxos availableUtxos
+        selectCollateral availableUtxos'
       else pure spendableUtxos
     -- otherwise, get all the utxos, filter out unspendable, and select
     -- collateral using internal algo, that is also used in KeyWallet
diff --git a/test/Testnet/Contract.purs b/test/Testnet/Contract.purs
index 7bf1b3d65..bcfdb3823 100644
--- a/test/Testnet/Contract.purs
+++ b/test/Testnet/Contract.purs
@@ -166,7 +166,7 @@ import Data.Either (Either(Left, Right), hush, isLeft, isRight)
 import Data.Foldable (fold, foldM, length)
 import Data.Lens (view)
 import Data.Map as Map
-import Data.Maybe (Maybe(Just, Nothing), fromJust, fromMaybe, isJust)
+import Data.Maybe (Maybe(Just, Nothing), fromJust, fromMaybe, isJust, maybe)
 import Data.Newtype (unwrap, wrap)
 import Data.Traversable (traverse, traverse_)
 import Data.Tuple (Tuple(Tuple))
@@ -223,7 +223,7 @@ suite = do
         withWallets distribution \alice -> do
           withKeyWallet alice ManyAssets.contract
     test
-      "#1509 - Collateral set to one of the inputs in mustNotSpendUtxosWithOutRefs "
+      "#1509 - Collateral set to one of the inputs in mustNotSpendUtxosWithOutRefs"
       do
         let
           someUtxos =
@@ -253,6 +253,57 @@ suite = do
               )
             res `shouldSatisfy` isLeft
 
+    test
+      "#1581 - Fallback to CTL collateral selection when all collateral inputs are non-spendable"
+      do
+        let
+          distribution =
+            [ BigNum.fromInt 10_000_000
+            , BigNum.fromInt 10_000_000
+            ]
+        withWallets distribution \alice ->
+          withKeyWallet alice do
+            validator <- AlwaysSucceeds.alwaysSucceedsScript
+            let vhash = validatorHash validator
+            logInfo' "Attempt to lock value"
+            txId <- AlwaysSucceeds.payToAlwaysSucceeds vhash
+            awaitTxConfirmed txId
+            logInfo' "Try to spend locked values"
+
+            scriptAddress <- mkAddress (wrap $ ScriptHashCredential vhash)
+              Nothing
+            utxos <- utxosAt scriptAddress
+            scriptUtxo <-
+              liftM
+                ( error
+                    ( "The id "
+                        <> show txId
+                        <> " does not have output locked at: "
+                        <> show scriptAddress
+                    )
+                )
+                $ head (lookupTxHash txId utxos)
+
+            unbalancedTx <- buildTx
+              [ SpendOutput scriptUtxo $ Just $ PlutusScriptOutput
+                  (ScriptValue validator)
+                  RedeemerDatum.unit
+                  (Just $ DatumValue PlutusData.unit)
+              ]
+
+            collUtxos <- getWalletCollateral
+            let
+              balancerConstraints =
+                maybe
+                  mempty
+                  (mustNotSpendUtxosWithOutRefs <<< Map.keys <<< toUtxoMap)
+                  collUtxos
+
+            balancedTx <- balanceTx unbalancedTx (toUtxoMap [ scriptUtxo ])
+              balancerConstraints
+            balancedSignedTx <- signTransaction balancedTx
+            submitAndLog balancedSignedTx
+
     test "#1480 - test that does nothing but fails" do
       let
         someUtxos =