Collateral is a finance term that defines any property or asset given by a borrower to a lender to help secure a loan. When you borrow money, you agree that your lender can take something and sell it to get their money back if you fail to repay the loan. Collateral makes it possible to get large loans, and it improves your chances of getting approved if you’re having a hard time getting a loan.
Loans with pledged collateral are known as “secured loans,” and are often required for most consumer loans.
Collateral and security are two terms that can be confused with one another. People often think the terms are one and the same. While collateral is defined as any property or asset that is given by the borrower to the lender, security refers to a broad set of financial assets used as collateral for a loan. Using securities when taking out a loan is called securities-based lending.
How collateral works
Loans that are 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.
Collateral is often required when the lender wants some assurance that they won’t lose all of their money. The borrower has a good reason to repay the loan on time because if she defaults on it, then she stands to lose her home or whatever other assets she has pledged as collateral. Upon default, the lender then takes possession of the collateral, sells it, and uses the sales proceeds to pay off the loan.
Collateral acts as a safeguard against legal action. After all, the lender’s main interest is in getting their money back, not in owning, renting, or selling property and other assets.
Examples of collateral
Any asset that your lender accepts as collateral (and that is allowed by law) can serve as collateral. In general, lenders prefer assets that are easy to value and turn into cash. For example, money in a savings account is great for collateral: lenders know how much it’s worth, and it’s easy to collect.
Most financial assets that can be seized and sold for cash are considered acceptable collateral, although each type of loan has different requirements. For a standard mortgage or auto loan, the home or car itself is used as collateral. With high-value personal loans, valuable possessions like jewelry or paintings are also accepted. When companies and small businesses apply for loans, they often put up equipment or other physical assets as collateral.
For borrowers with poor credit, pledging a collateral asset can improve the chances of getting approved for a loan. Collateral demonstrates a consumer’s commitment to repaying the loan and lowers the risk of loss to the lender. Loans secured with collateral also tend to have lower interest rates, which can save thousands of dollars in the long term. However, other factors like credit score, income, and job stability will also influence your loan approval chances and interest rate.
The types of collateral that lenders commonly accept include:
cars (if they are paid off in full)
real estate (including equity in your home)
cash accounts (retirement accounts typically don’t qualify, although there are always exceptions)
machinery and equipment
investments
insurance policies
valuables and collectibles
future payments from customers, called receivables
Home buying collateral
A mortgage is a loan in which the house is the collateral. If the homeowner stops paying the mortgage, the lender can take 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.
A home may also function as collateral on a second mortgage or home equity line of credit. In this case, the amount of the loan will not exceed the available equity.
Margin trading collateral
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 that the investor can buy, multiplying the potential gains if the shares increase in value.
However, in margin trading, 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. From a risk aversion perspective, this type of collateral is not advisable.
Blanket liens
A blanket lien is a lien that gives the right to seize, in the event of nonpayment, all types of assets serving as collateral owned by a debtor. A blanket lien, theoretically, gives a creditor a legal interest in all of the debtor’s assets.
Types of loans that may require collateral
Personal loans
Personal loans are used by consumers to consolidate existing debt, build credit or finance everyday expenses. These loans are offered by lenders in two main types: secured and unsecured.
Secured personal loans are backed by collateral, while unsecured loans are not. As collateral reduces the lender’s exposure to the risk of default, secured personal loans have lower interest rates than their unsecured counterparts. Besides physical property like houses or vehicles, monetary assets like investments, savings, or future paychecks can also be used as collateral for a personal loan.
Small business loans
Small business loans are a popular way to support a growing business, and can be used to finance hiring, office space, or equipment. Collateral for these loans can include real estate, future payments by customers, and inventory.
Owners of small businesses can also use their personal assets, such as a family home, to gain approval for a loan, especially when running a business out of their home. This “personal guarantee” is a written promise that the borrower’s personal assets can be seized if the company defaults on its debts.
Mortgages and auto loans
Mortgages and auto loans are the most common types of secured loans used by consumers.
As mentioned previously, the asset being purchased (that is, the house or car) is used as collateral for these loans. Most lenders mandate that assets be appraised to determine the proper value of the collateral. This process is particularly important for mortgage applicants, as lenders only approve home loans if the appraisal value of the home matches or exceeds the sale price.
