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What is Collateral?

How Collateral Works

Different kinds of collateral

Examples of Collateral Loans

Personal Finance Loans

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?

The collateral in the world of finance is an asset of value that is pledged by a borrower to secure the loan.

When a homebuyer obtains a mortgage, the home is used as security for the loan. In the case of a car loan, the vehicle is the collateral. The business that gets finance from a bank can pledge valuable assets or real estate owned by the business to secure the loan.

An loan made with collateral is characterized by a an interest rate that is lower than an unsecure loan. If there is a failure to pay, the loaner is able to confiscate the collateral and sell it to recoup the loss.

Important Takeaways

Collateral is a piece 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 take the collateral and then sell it in order to recover its losses.

Car loans are two kinds of collateralized loans.

Personal assets like such as the savings or investment account, are able to be used to get an unsecured personal loan.

How Collateral Works

When a lender offers you a loan they want to ensure that you have the ability to repay it. That’s why many of them require some type of security. This security is called collateral which minimizes the risks for the lenders. It ensures that the borrower keeps up with their financial obligation. In the event that the borrower defaults the lender may confiscate the collateral and transfer the proceeds to the remaining balance 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 take many forms. It usually relates to the character of the loan and, for example, the collateral for a mortgage is the home, while the collateral for a car loan is the car in question. Personal, non-specific loans can be collateralized through other assets. For instance a secured credit card may be secured with deposits in cash for the same amount as the credit limit, i.e. $500 for a $500 credit limit.

Secured loans secured by collateral are typically available at substantially lower interest rates than unsecured loans. The lender’s claim on a borrower’s collateral is called a lien—a legally binding right, or claim on an asset in order to pay the obligation. The borrower must have an incentive to pay back the loan promptly in case of default because they could lose their home or any other asset secured as collateral.

Different types of collateral

The nature of the collateral is typically determined by the loan kind. If you get an mortgage, your home becomes the collateral. If you take out an auto loan, then the car will be the collateral for the loan. The kinds of collateral lenders commonly accept include cars—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, and not just by payday lending companies. Banks that are traditional offer these loans generally with terms that are not more than a few weeks. These short-term loans can be used in an emergency situation however it is important to read the fine print carefully and check rates.

Collateralized Personal Loans

Another type of borrowing is the collateralized personal loan, in which the borrower provides something of value as security to secure an loan. The value of the collateral must equal or exceed the amount of money being borrowed. If you’re thinking about the collateralization of a personal loan, your best choice for a lender is probably an institution with which you have already established a relationship with, particularly if your deposit is in your account at a savings. In the event that you have an existing relationship with your bank the institution would be more inclined to approve the loan, and you are more apt to get an acceptable rate.

Use a financial institution with whom you have already established a relationship when you’re looking at an uninvolved 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 at least 120 days after which the loan servicer can begin legal proceedings which can lead to the lender eventually getting possession of the house by foreclosure.1 After the property has been transferred to the lender, it is then sold to repay the remaining principal on the loan.

Home Equity Loans

A home may also function as collateral on a second the mortgage, or a home equity line of credit (HELOC). In this instance you can guarantee that your loan cannot exceed the equity available. For instance, if the home is worth $200,000 and $125,000 remains in the primary mortgage the second mortgage, or HELOC will be available only up to $75,000.

Margin Trading

Collateralized loans are also an element in margin trading. Investors borrow the funds of a broker in order to buy shares, using the balance in the investor’s broker account for collateral. The loan will increase the amount of shares an investor is able to purchase, multiplying the potential gains should the shares appreciate in value. However, the risks are multiplied. If the shares fall in value, the broker can demand payment in the amount of difference. In that case the account is used as collateral if the borrower is unable to pay for the loss.

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