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What is Collateral?

How Collateral Works

Different kinds of collateral

Illustrations for Collateral Loans

Personal Finance Credit

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?

The collateral in the world of finance is an asset of value that a borrower pledges as security to secure the loan.

When a homeowner gets an mortgage, the property is used as security for the loan. When it comes to a car loan, the vehicle is the collateral. Businesses that get financing from a bank may offer important equipment or real property owned by the company as collateral for the loan.

An loan that is secured by collateral comes with a lower interest rate than an unsecure loan. In the event of a insolvency, the lending institution can confiscate the collateral and trade it for a profit to cover the losses.

The most important takeaways

Collateral is a piece that is of value and can be pledged to secure a loan.

Collateral reduces the risk for lenders.

If a borrower defaults on the loan the lender may seize the collateral and sell it in order to recover its losses.

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

Additional personal possessions, such as an investment or savings account, can be used to obtain an unsecured personal loan.

How Collateral Works

When a lender offers you a loan the lender wants to ensure that you’re able to repay it. This is why many lenders require some type of security. The security is known as collateral that reduces the chance for lending. 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 take the collateral and then trade it in, transferring the money it gets to the portion that is not paid of the loan. The lender is able to pursue legal action against the borrower to recoup any balance remaining.

As we mentioned earlier, collateral can take many forms. It is usually related to the nature of the loan which is why the collateral for a mortgage is the home, while the collateral for car loan is the car in question. Personal loans may be secured by other assets. For instance, a secured credit card may be secured by deposits in cash for exactly the same amount as the credit limit — $500 for a credit limit of $500.

Secured loans secured by collateral are typically available at substantially lower rates of interest than unsecured loans. A lender’s claim to a borrower’s collateral is called a lien—a legally binding right, or claim on an asset to satisfy the debt. The borrower has an incentive to pay back the loan in full since if they fail to pay, they risk losing their home or other property that are pledged as collateral.

Different types of collateral

The nature of the collateral is often predetermined by the loan type. If you get a mortgage, your house becomes the collateral. If you take out a car loan and the car is 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 are not usually considered collateral.

You also may use future paychecks as collateral for short-term loans that are not only through payday loan lenders. Banks that are traditional offer these loans generally for terms no longer than a couple of weeks. These short-term loans are an option in a genuine emergency but, even in that case you must read the fine print carefully and look at rates.

Collateralized Personal Loans

Another form that borrows money is the personal collateralized loan where the borrower pledges something of value as security to secure the loan. The value of the collateral must meet or exceed the amount of money being borrowed. If you’re considering a personal collateralized loan, your best choice for a lender is probably a financial institution that you already have a relationship with, particularly if your security is your bank account. In the event that you have an existing relationship to the institution, that bank is more likely to accept the loan and you’re more apt to get an affordable rate.

Make sure to choose a financial institution with which you have a previous relationship if you’re considering a collateralized personal loan.

Illustrations for Collateral Loans

Residential Mortgages

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

Home Equity Loans

A home may also function as collateral on the second loan, such as a mortgage or home equity line (HELOC). In this case you can guarantee that your loan is not greater than the equity available. For example, if a home is worth $200,000 and $125,000 is left 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 broker account for collateral. The loan increases the number of shares that the investor is able to purchase, multiplying the potential gains when the shares rise in value. But the risks are also multiplied. If the shares decrease in value, the broker demands the amount in the amount of difference. In that case, the account serves as collateral if the borrower fails to cover the loss.