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What is Collateral?

How Collateral Works

Different types of collateral

Exemples of Collateral Loans

Personal Finance Credit

Collateral Definition, Types, & Examples

By Julia Kagan

Updated September 25, 2022

Reviewed by Amy Drury

Checked for accuracy by Ryan Eichler

Collateral

Investopedia / Zoe Hansen

What Is Collateral?

Collateral in the financial world is an asset of value that a borrower pledges as security to secure a loan.

When a homeowner gets a mortgage, the house is used as security for the loan. When it comes to a car loan the car is the collateral. A business that obtains finance from a bank can pledge valuable equipment or real property owned by the business to secure the loan.

An loan made with collateral comes with an interest rate that is lower than an unsecured loan. In the event of a failure to pay, the loaner is able to seize the collateral and sell it to recoup the losses.

The most important takeaways

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

Collateral decreases the risk of lenders.

If a borrower is in default on the loan The lender has the right to seize the collateral and trade it in to cover its losses.

Car loans are two types of collateralized loans.

Additional personal possessions, such as a savings or investment account, are able to be used to secure an unsecured personal loan.

How Collateral Works

Before a lender gives you with a loan the lender wants to ensure that you are able to pay back the loan. This is why many lenders require some type of security. This security is called collateral that reduces the chance for lending. It is a way to ensure that the borrower keeps up with their financial obligations. If the borrower defaults the lender may confiscate the collateral and transfer the money it gets to the unpaid portion of the loan. The lender may decide to take legal action against the borrower to recover any remaining balance.

As previously mentioned collateral comes in a variety of forms. It usually relates to the character of the loan and, for example, a mortgage is collateralized by the home, and the collateral for the car loan is the vehicle in question. Personal, non-specific loans are secured by other assets. For instance the secured credit card could be secured by deposits in cash for exactly the same amount as the credit limit–$500 for a $500 credit limit.

Secured loans secured by collateral are usually offered at significantly lower interest rates than unsecured loans. The lender’s claim on the collateral of a borrower is known as an lien, which is a legal right or claim against an asset in order to pay the obligation. The borrower must have a compelling reason to repay the loan on time in case of default because they risk losing their home or any other asset secured as collateral.

Types of Collateral

The nature of the collateral is usually determined by the loan kind. When you take out a mortgage, your house becomes the collateral. If you get the car loan, then the car is the collateral for the loan. The types of collateral that banks typically accept are cars, but only in the event that they are paid in full, such as bank savings deposits and investments accounts. Retirement accounts aren’t typically accepted as collateral.

You can also utilize future paychecks as collateral for short-term loans, and not just from payday lenders. Banks that are traditional offer these loans generally for terms of no more than a few weeks. These short-term loans are an option in an emergency situation however, you should read the fine print carefully and look at rates.

Collateralized Personal Loans

Another form of loan is the personal collateralized loan, in which the borrower offers an item of value in exchange for security to secure an loan. The collateral’s value must meet or exceed the amount of money being borrowed. If you’re considering the collateralization of a personal loan, your best choice for a lender is likely an institution you already have a relationship with, particularly if the deposit is in your account at a savings. When you’ve already established a relationship with the bank, that bank is more likely to approve the loan and also likely to receive an acceptable rate.

Choose a bank with which you already have a relationship if you’re considering an uninvolved personal loan.

Illustrations for Collateral Loans

Residential Mortgages

A mortgage is an loan where the house is the collateral. If the homeowner does not pay the mortgage for at least 120 days after which the loan servicer may initiate legal proceedings, which could cause the lender to eventually becoming the owner of the home through foreclosure.1 When the property is handed over to the lender, it may be sold to repay the principal balance on the loan.

Home Equity Loans

A home may also function as collateral for an additional the mortgage, or a home equity line of credit (HELOC). In this case, it is important that the total amount for the loan will not exceed the equity available. For instance, if the home is valued at $200,000 and $125,000 remains on the primary mortgage A second mortgage or HELOC is available up to $75,000.

Margin Trading

Collateralized loans can also be a factor when it comes to margin trading. Investors borrow money from a broker to buy shares, using the balance of the investor’s broker account for collateral. The loan will increase the amount of shares an investor can buy, thus increasing the potential gain should the shares appreciate in value. However, the risks are multiplied. If the shares decrease from value to the point that the broker can demand payment of the difference. In this case the account acts as collateral if the lender does not cover the cost.

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