What Is Collateral?
Let me explain collateral to you directly: it's a valuable asset that you, as a borrower, pledge to a lender as security for a loan, acting as a guarantee if things go wrong.
For instance, when you're buying a home with a mortgage, the house itself becomes the collateral. The same goes for a car loan where the vehicle secures the debt. If you're running a business and need financing, you might pledge equipment or real estate owned by the company. Should you default, the lender can take that collateral and sell it to cover their losses.
Even for other personal loans, you can use various assets as collateral. Take a secured credit card, for example—it's often backed by a cash deposit equal to the credit limit, say $500 for a $500 limit.
Key Takeaways
- Collateral reduces the risk for lenders.
- If you default on the loan, the lender can seize the collateral and sell it to recoup losses.
- Mortgages and car loans are two types of collateralized loans.
- Other personal assets, such as a savings or investment account, can secure a collateralized personal loan.
How Collateral Works
Before issuing you a loan, a lender needs assurance that you'll repay it, which is why they often require collateral as security. This minimizes their risk because it gives you a strong incentive to meet your obligations—if you default, you could lose your home or other pledged assets.
Loans secured by collateral usually come with lower interest rates than unsecured ones. The lender's claim on your collateral is known as a lien, which is their legal right to the asset to satisfy the debt.
If you do default, the lender can seize the collateral, sell it, and apply the proceeds to the unpaid loan balance. They might even take legal action against you for any remaining amount.
Types of Collateral
The type of collateral often depends on the loan itself. For a mortgage, it's your home; for a car loan, it's the vehicle. Lenders commonly accept paid-off cars, bank savings deposits, or investment accounts as collateral, but retirement accounts are typically not allowed.
You can also use future paychecks for very short-term loans, not just from payday lenders—traditional banks offer these too, often for just a couple of weeks. These are for genuine emergencies, but always read the fine print and compare rates carefully.
Collateralized Personal Loans
With a collateralized personal loan, you offer something valuable as security, and its value must at least match or exceed the loan amount.
Lenders usually only lend a percentage of the collateral's value, not the full amount. If you're thinking about this, start with your current bank, especially if your savings account is the collateral—they're more likely to approve it and give you a good rate since you already have a relationship.
Important Advice
Consider your current financial institution for a collateralized personal loan, but shop around with other lenders to find the best rates.
Examples of Collateral Loans
Let's look at residential mortgages: here, the house is the collateral. If you stop paying for at least 120 days, the servicer can start foreclosure proceedings, potentially taking possession of the home and selling it to repay the loan.
Homes can also secure second mortgages or home equity lines of credit (HELOCs). The loan amount won't exceed your available equity—for a $200,000 home with $125,000 left on the primary mortgage, you'd only get up to $75,000.
In margin trading, you borrow from a broker to buy shares, using your brokerage account balance as collateral. This amplifies potential gains but also risks—if shares drop, you might have to cover the difference, or the account gets seized.
Is Collateral Property?
Collateral guarantees a loan, so it has to be something valuable, like property such as a car or home, or even cash that the lender can take if you don't pay.
What Loans Do Not Use an Asset as Collateral?
If you lack collateral for a secured loan, consider unsecured options like personal loans or credit cards, which don't require assets but might have higher rates.
Do I Get Back My Collateral?
As long as you make all payments on time and don't default, you keep your collateral. But if you miss payments and default, it can be seized, sold, and the proceeds used to pay off the loan.
The Bottom Line
You risk losing your collateral if you don't repay your debt, so always make payments on time to avoid defaulting and keep your car, home, or other assets safe.
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