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What is Collateral?

How Collateral Works

Different types of collateral

Exemples of Collateral Loans

Personal Finance Lending

Collateral Definition, Types, & Examples

By Julia Kagan

Updated September 25, 2022

Read by Amy Drury

Checked for accuracy by Ryan Eichler

Collateral

Investopedia / Zoe Hansen

What Is Collateral?

The collateral in the world of finance is a valuable asset is pledged by a borrower as security for the loan.

When a homebuyer obtains a mortgage, the home serves as the collateral for the loan. In the case of a car loan, the vehicle is the collateral. Businesses that get finance from a bank can offer valuable equipment or real property owned by the company as collateral for the loan.

A loan made with collateral has the lowest interest rate than an unsecured loan. In the event of default, the lender could take the collateral and then trade it for a profit to cover the loss.

Key Takeaways

Collateral is a piece of value pledged to help secure the loan.

Collateral reduces the risk for lenders.

If a borrower defaults on the loan the lender may take the collateral and then sell it to recoup its loss.

Mortgages and car loans are two types of collateralized loans.

Other personal assets, such as a savings or investment account, could be used to secure a collateralized personal loan.

How Collateral Works

When a lender offers you a loan they want to ensure that you’re able to pay back the loan. That’s why many of them require some type of security. This security is called collateral which minimizes the risk for lenders. It helps to ensure that the borrower is in compliance with their financial obligations. In the event that the borrower does default the lender may seize the collateral and sell it, applying the money it gets to the portion that is not paid that is due to the loan. The lender is able to pursue legal action against the borrower to recover any remaining balance.

As we mentioned earlier collateral can come in many forms. It is usually related with the type of loan which is why the mortgage is secured by the house, whereas the collateral for the automobile loan is the car that is being used. Other nonspecific, personal loans may be secured by other assets. For instance, a secured credit card could be secured by a cash deposit for the same amount of the credit limit, i.e. $500 for a credit limit of $500.

Loans secured by collateral are usually offered at significantly lower rates of interest than unsecure loans. A lender’s claim on the collateral of a borrower is known as a lien. It is a legitimate right to claim an asset to satisfy the obligation. The borrower must have an incentive to pay back the loan promptly in case of default because they stand to lose their home or other property pledged as collateral.

Different types of collateral

The character of the collateral is often predetermined by the loan type. If you are taking out a mortgage, your house becomes the collateral. If you are taking out the car loan, then the car will be the collateral for the loan. The types of collateral that banks typically accept are cars, but only if they are paid off in full, such as bank savings deposits and investments accounts. Retirement accounts aren’t usually accepted as collateral.

You can also make use of future pay checks as collateral for very short-term loans but not just through payday loan lenders. Traditional banks offer such loans, usually with terms that are not more than a few weeks. These short-term loans can be used in a genuine emergency but, even in that case you must be sure to read the fine print and check rates.

Collateralized Personal Loans

Another kind of borrowing is the personal collateralized loan where the borrower pledges an item of value in exchange for security to secure a loan. The value of the collateral must equal or exceed the amount that is being loaned. If you’re thinking about the collateralization of a personal loan, your best choice for a lender is probably a financial institution that you already have a relationship with, particularly if the collateral is your savings account. When you’ve already established a working relationship with your bank the institution will be more likely to grant the loan, and you are more apt to get an acceptable rate.

Make sure to choose a financial institution with which you have a previous connection if you’re thinking of getting a collateralized personal loan.

Illustrations for Collateral Loans

Residential Mortgages

A mortgage is an loan that uses the home as is the collateral. If the homeowner fails to pay the mortgage for a minimum of 120 days after which the loan servicer can begin legal proceedings, which could cause the lender to eventually getting possession of the property through foreclosure.1 Once the property is transferred to the 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 on an additional the mortgage, or a home equity line of credit (HELOC). In this case, the amount of the loan will not exceed the available equity. For instance, if a home is valued at $200,000 and $125,000 remains in the primary mortgage A second mortgage or HELOC can be obtained up to $75,000.

Margin Trading

Collateralized loans are also a factor for margin trades. An investor borrows money from a broker to purchase shares, using the balance in their brokerage account as collateral. The loan will increase the number of shares that the investor can buy, thus increasing the gains that could be earned should the shares appreciate in value. However, the risks are multiplied. If the shares decrease by value, then the broker can demand payment for the loss. In that situation, the account serves as collateral if the lender does not cover the cost.