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What Is Collateral?

How Collateral Works

Different kinds of collateral

Exemples of Collateral Loans

Personal Finance Credit

Collateral Definition, Types, & Examples

By Julia Kagan

Updated September 25, 2022

Reviewed 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 the borrower can pledge as security for the loan.

When a homeowner gets a mortgage, the house serves as the security for the loan. When it comes to an automobile loan the car is the collateral. A business that obtains funding from a lender may offer important equipment or real property owned by the business as collateral for the loan.

A loan that is secured by collateral is characterized by a an interest rate that is lower than an unsecured loan. If there is a failure to pay, the loaner could seize the collateral and trade it for a profit to cover the losses.

Key Takeaways

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

Collateral decreases the risk of lenders.

If a borrower defaults on the loan The lender has the right to seize the collateral and sell it to recoup its loss.

Car loans are two forms of collateralized loans.

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

How Collateral Works

Before a lender issues you a loan, it wants to be sure that you are able to repay it. That’s why many of them require some sort of security. This is referred to as collateral that reduces the risks for the lenders. It helps to ensure that the borrower is in compliance with their financial obligation. If the borrower fails to pay the lender may take the collateral and then transfer the money it gets to the unpaid portion of the loan. The lender can choose to pursue legal action against the borrower to recoup any balance remaining.

As mentioned above, collateral can take many forms. It is usually related to the character of the loan and, for example, the mortgage is secured by the house, whereas the collateral for car loan is the car the loan is secured by. Other nonspecific, personal loans can be collateralized by other assets. For instance, a secured credit card can be secured by a cash deposit for exactly the same amount as the credit limit, i.e. $500 for a $500 credit limit.

Loans secured by collateral are typically available at substantially lower rates of interest than unsecured loans. A lender’s claim on the collateral of a borrower is known as a lien–a legal right or claim against an asset in order to pay the debt. The borrower has the need to pay the loan promptly in case of default because they stand to lose their home or any other asset secured as collateral.

Different kinds of collateral

The type of collateral is usually determined by the loan type. When you take out an mortgage, your home is the collateral. If you are taking out an auto loan, then the car is the collateral for the loan. The types of collateral that lenders commonly accept include cars–only in the event that they are paid in full, bank savings deposits and investment accounts. Retirement accounts aren’t usually accepted as collateral.

You also may utilize future paychecks as collateral for short-term loans, and not just through payday loan lenders. Traditional banks offer such loans generally with terms that are not more than a couple of weeks. These short-term loans can be used in an emergency situation however you must be sure to read the fine print and compare rates.

Collateralized Personal Loans

Another form that borrows money is the collateralized personal loan where the borrower offers an item of value as security to secure a loan. The collateral’s value must be greater than or equal to the amount of money being borrowed. If you are considering the collateralization of a personal loan the best option for a lender is likely an institution with which you already do business with, especially if your collateral is your savings account. When you’ve already established a connection with the bank, they would be more inclined to grant the loan and also more apt to get a decent rate for it.

Choose a bank that you have a previous relationship if you’re considering an uninvolved personal loan.

Illustrations for Collateral Loans

Residential Mortgages

A mortgage is an loan in which the house is the collateral. If the homeowner does not pay the mortgage for at least 120 days after which the loan servicer could initiate legal proceedings, which could result in the lender ultimately getting possession of the home by foreclosure.1 When the property is handed over to the lender, it can be sold to pay back the remainder of the principal loan.

Home Equity Loans

A home can also serve as collateral for the second the mortgage, or a 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, a second mortgage or HELOC can be obtained for as much as $75,000.

Margin Trading

Collateralized loans are also a factor when it comes to margin trading. Investors borrow the funds of a broker in order to buy shares, using the balance of the investor’s brokerage account as collateral. The loan will increase the number of shares that the investor can buy, thus increasing the potential gain if the shares increase in value. However, the risk is multiplied. If the shares decrease by value, then the broker will demand the amount in the amount of difference. In that case the account is used as collateral if the borrower does not cover the loss.

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