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What is Collateral?

How Collateral Works

Different types of collateral

Examples of Collateral Loans

Personal Finance Lending

Collateral Definition, Types, & Examples

By Julia Kagan

Updated September 25, 2022

Review by Amy Drury

The factual information was checked by Ryan Eichler

Collateral

Investopedia / Zoe Hansen

What Is Collateral?

In the world of finance, collateral is a valuable asset is pledged by a borrower to secure the loan.

When a homebuyer obtains an mortgage, the property is used as source of collateral to the loan. For a car loan the vehicle serves as the collateral. The business that gets financing from a bank may offer valuable equipment or real estate owned by the business to secure the loan.

A loan that is secured by collateral has an interest rate that is lower than an unsecure loan. In the event of a default, the lender can confiscate the collateral and trade it for a profit to cover the loss.

Important Takeaways

Collateral is an asset of value pledged to ensure the security of a loan.

Collateral decreases the risk of lenders.

If a borrower defaults on the loan, the lender can confiscate the collateral and sell it in order to recover its loss.

The mortgage and the car loans are two kinds of collateralized loans.

Personal assets like including the savings or investment account, could be used to obtain an unsecured personal loan.

How Collateral Works

Before a lender gives you a loan they want to ensure that you’re able to pay it back. This is why many lenders require some sort of security. This is referred to as collateral which minimizes the chance for lending. It helps to ensure that the borrower is in compliance with their financial obligations. If the borrower fails to pay the lender may take the collateral and then trade it in, transferring the proceeds to the remaining balance that is due to the loan. The lender is able to pursue legal action against the borrower to recover any remaining balance.

As mentioned above collateral can come in many forms. It normally relates to the character of the loan which is why the collateral for a mortgage is the home, while the collateral for a vehicle loan is the car that is being used. Personal, non-specific loans are secured through other assets. For example a secured credit card can be secured by deposits in cash for exactly the same amount as the credit limit – $500 for a $500 credit limit.

Loans secured by collateral are generally offered at lower rates of interest than unsecured loans. A lender’s claim on the collateral of a borrower is known as an lien, which is a legitimate right to claim an asset in order to pay the debt. The borrower must have a compelling reason to repay the loan on time because if they default, they stand to lose their home or any other asset that are pledged as collateral.

Types of Collateral

The type of collateral is often predetermined by the loan kind. If you are taking out an mortgage, your home is the collateral. If you get an auto loan, then your car will be the collateral for the loan. The kinds of collateral lenders commonly accept include cars–only in the event that they are paid in full–bank savings deposits, and investments accounts. Retirement accounts aren’t usually considered collateral.

It is also possible to make use of future pay checks as collateral for short-term loans that are not only by payday lending companies. Traditional banks provide these loans, usually with terms that are not more than a couple of weeks. These short-term loans are an option in the event of a real emergency but, even in that case you must take note of the fine print and check rates.

Collateralized Personal Loans

Another kind that borrows money is the personal collateralized loan where the borrower provides something of value as security for the loan. The value of the collateral must be greater than or equal to the amount being loaned. If you’re thinking about the collateralization of a personal loan the best option for a lender is likely an institution you already have a relationship with, especially if your security is your bank account. When you’ve already established a connection with your bank that bank is more likely to grant the loan and you’re more apt to get an affordable rate.

Use a financial institution with whom you have a previous relationship when you’re looking at a collateralized personal loan.

Examples of Collateral Loans

Residential Mortgages

A mortgage is a loan that uses the home as serves as collateral. If the homeowner stops paying the mortgage for at least 120 days after which the loan servicer can begin legal proceedings, which could result in the lender ultimately getting possession of the house by foreclosure.1 Once the property is given to the loan lender it can be sold to pay back the principal balance on the loan.

Home Equity Loans

A home could also be used as collateral for a second mortgage or home equity line of credit (HELOC). In this scenario, 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 mortgage that is primary the second mortgage, or HELOC will be available only up to $75,000.

Margin Trading

Collateralized loans are also an element when it comes to margin trading. A buyer borrows the money of a broker to buy shares, using the balance of the investor’s broker account for collateral. The loan can increase the amount of shares an investor can buy, thus multiplying the potential gains should the shares appreciate in value. However, the risks are multiplied. If the shares fall in value, the broker demands the amount in the amount of difference. In that case the account acts as collateral if the lender is unable to pay for the cost.