Collateral in the financial world is a valuable asset that a borrower pledges as security for a loan.
For example, when a homebuyer obtains a mortgage, the home serves as the collateral for the loan. For a car loan, the vehicle is the collateral. A business that obtains financing from a bank may pledge valuable equipment or real estate owned by the business as collateral for the loan. In the event of a default, the lender can seize the collateral and sell it to recoup the loss.
Other nonspecific personal loans can be collateralized by other assets. For instance, a secured credit card may be secured by a cash deposit for the same amount of the credit limit — $500 for a $500 credit limit.
Key Takeaways
- Collateral is an item of value pledged to secure a loan.
- Collateral reduces the risk for lenders.
- If a borrower defaults on the loan, the lender can seize the collateral and sell it to recoup its losses.
- Mortgages and car loans are two types of collateralized loans.
- Other personal assets, such as a savings or investment account, can be used to secure a collateralized personal loan.
How Collateral Works
Before a lender issues you a loan, it wants to know that you have the ability to repay it. That’s why many of them require some form of security. This security is called collateral, which minimizes the risk for lenders by ensuring that the borrower keeps up with their financial obligation. The borrower has a compelling reason to repay the loan on time because if they default, they stand to lose their home or other assets pledged as collateral.
Loans secured by collateral are typically available at substantially lower interest rates than unsecured loans. A lender’s claim to a borrower’s collateral is called a lien — a legal right or claim against an asset to satisfy a debt.
In the event that the borrower does default, the lender can seize the collateral and sell it, applying the money to the unpaid portion of the loan. The lender can choose to pursue legal action against the borrower to recoup any remaining balance.
Types of Collateral
The nature of the collateral is often predetermined by the loan type. When you take out a mortgage, your home becomes the collateral. If you take out a car loan, then the car is the collateral for the loan. The types of collateral that lenders commonly accept include cars — only if they are paid off in full — bank savings deposits, and investment accounts. Retirement accounts are not usually accepted as collateral.
You also may use future paychecks as collateral for very short-term loans from lending institutions. These short-term loans are an option in a genuine emergency, but even then, you should read the fine print carefully and compare rates.
Collateralized Personal Loans
Another type of borrowing is the collateralized personal loan, in which the borrower offers an item of value as security for a loan. The value of the collateral must meet or exceed the amount being loaned. Lenders will typically lend only a percentage of the collateral’s value, not 100% of its value. If you are considering a collateralized personal loan, your best choice for a lender is probably a financial institution that you already do business with, especially if your collateral is your savings account. If you already have a relationship with the bank, that bank would be more inclined to approve the loan, and you are more apt to get a decent rate for it.
Examples of Collateral Loans
Residential Mortgages
A mortgage is a loan in which the house is the collateral. If the homeowner stops paying the mortgage for at least 120 days, the loan servicer can begin legal proceedings, which can lead to the lender eventually taking possession of the house through foreclosure. Once the property is transferred to the lender, it can be sold to repay the remaining principal on the loan.
Home Equity Loans
A home may also function as collateral on a second mortgage or home equity line of credit (HELOC). In this case, the amount of the loan will not exceed the available equity. For example, if a home is valued at $200,000 and $125,000 remains on the primary mortgage, a second mortgage or HELOC will be available only for as much as $75,000.
Margin Trading
Collateralized loans are also a factor in margin trading. An investor borrows money from a broker to buy shares, using the balance in the investor’s brokerage account as collateral. The loan increases the number of shares the investor can buy, thus multiplying the potential gains if the shares increase in value. But the risks are also multiplied. If the shares decrease in value, the broker demands payment of the difference. In that case, the account serves as collateral if the borrower fails to cover the loss.
Is Collateral Property?
Collateral guarantees a loan, so it needs to be an item of value. For example, it can be a piece of property, such as a car or a home, or even cash that the lender can seize if the borrower does not pay.
What Loans Do not Use an Asset as Collateral?
If you don’t have any collateral necessary to secure a certain type of loan, you may want to consider looking into unsecured loans, such as a personal loan or credit card (both of which don’t use an asset as collateral), as an alternative.
Do I Get Back My Collateral?
If you have any assets being used as collateral on a loan and don’t miss any payments, you won’t lose your collateral. However, if you fail to make payments on time and ultimately default on your loan, the collateral can then be seized and sold, with the profits being used to pay off the remainder of the loan.
The Bottom Line
You risk losing your collateral if you fail to pay back your debt. So to ensure you keep your car, home, or any other valuable asset being used as collateral on a loan, always make your payments on time to minimize any possibility of defaulting on your debt.
References
- Consumer Financial Protection Bureau. “1024.41 Loss Mitigation Procedures”.
