They replied saying they want cash + the two months security deposit they paid.  

If you are dealing in higher priced areas, it can be harder for buyers to come up with larger sums of cash and if you can't flip a property to another investor before closing, you'll have to come up with all cash or lose the deal and your security deposit.

The nice thing about buying from other landlords is that since they're already used to getting monthly payments (rent) with small downs (security deposits) they're often very receptive to selling on land contract or other forms of seller financing.

I am considering lending them this amount but would like to secure the loan with collateral. 1.

If you deny an applicant or take any adverse action (i.e. charge higher security deposit, require co-signer, etc) based on information in their consumer credit file, then you should be sending them an adverse action letter which basically tells them what consumer reporting agency supplied the info you relied on, the contact info for that agency, and how they can get a free copy of their own credit report. 

Any loan you want to take against the whole life policy is secured with the policy values, which are restored when the loan is paid off.

Will a rent credit trigger the Frank-Dodd Act, or qualify as some sort of securities trading?

I'm now trying to secure some funding so that I can move forward.  

Her income is only $1300/month of Social Security.  

You'd be able to secure favorable, owner-occupied financing; force some sweat equity; get your feet wet as a landlord and start to learn the ropes; and down the line, depending on how things go, you could turn it into a full-time rental and either rinse or repeat or move onto a different strategy to obtain future rentals.