What Is Collateral And How Does It Work?
Hanna Kielar4 minute read
UPDATED: March 13, 2023
You’ve probably heard the term “collateral” used when applying for a mortgage, car loan or maybe even a credit card. Lending institutions use collateral to help protect their investment in case the borrower defaults on the loan.
Let’s discuss what collateral is, how it works and the types of collateral you can use the next time you apply for financing.
What Is Collateral?
Collateral is an asset (tangible or intangible) that a lender requires before they secure a loan. Lenders can use the collateral to further incentivize the borrower to uphold the loan’s terms. Or, if a borrower defaults on the loan, the lender will claim the item and sell it to help cover their losses.
Lenders such as banks and credit unions accept a wide variety of items for collateral. However, anything you use must be high enough in value to meet the lender’s requirements, thus protecting the lender appropriately.
How Does Collateral Work?
The type of collateral you can use may depend on the loan you’re applying for. Some loans use the item you’re financing, such as a home for a mortgage loan or a vehicle for a car loan. Other types of collateral will require various items of value, like a savings account or certificate of deposit (CD).
When you apply for a collateralized loan or line of credit, the lender will first check your financial situation so they can feel confident you’ll repay the loan. The lender will run your credit, check your payment history and calculate your debt-to-income ratio. Then they’ll appraise the item put up for collateral to help determine your total loan amount.
How Does Collateral Work For A Personal Loan?
Most personal loans are unsecured. A personal loan with collateral is secured by the value of its associated collateral. For example, let’s say you decide to take out a personal loan to cover the cost of replacing your refrigerator. The model you want costs $2,000, so the item you use for collateral must be valued at the same amount or more.
If you decide to use your car, which has an appraised value of $3,000, the lender should approve your loan. That’s because the vehicle is worth more than $2,000 and therefore appropriately secures the amount you’re borrowing.
What About Collateral In Finance?
Collateral isn’t only used for mortgages and loans. It’s also a security measure leveraged by investment brokers, but you’ll probably hear it referred to as “margin trading.”
Margin trading occurs when an investor borrows money from a brokerage to finance the purchase of stocks. The investor will use their portfolio to help secure the loan. This method can help an investor purchase more stocks than they could without the loan, but it also increases their risk if the shares decrease in value.
Types Of Collateral Loans
The type of collateral loan you use depends on what you’re trying to purchase and your financial goals. Below are the most common forms of collateral that financial institutions offer:
- Mortgages: Also called a home loan, a mortgage finances the purchase of real estate. A mortgage uses the property you’re buying to secure the loan.
- Car loans: The vehicle you’re purchasing will be the collateral for an auto loan.
- Secured credit cards: This type of credit card uses a cash deposit as collateral. If you miss payments, the card provider can use the cash to cover your outstanding balance.
- Secured personal loans: Most lenders will accept an asset like a car, a home or a savings account for a personal loan.
- Home equity loans: This type of loan uses your home as collateral, like a mortgage. So if you stop paying the loan, you could lose your house.
- Small-business loans: Some lenders will require collateral for a small-business loan. You could use the assets of your business – such as the building, equipment or accounts receivable – as collateral.
Examples Of Collateral For A Secured Loan
Along with the forms of collateral mentioned above, lending institutions may accept the following types of collateral for a loan:
- Vehicles (boats, cars, motorcycles or RVs)
- Investment products (stocks, bonds or mutual funds)
- Insurance policies
- Valuables (fine art, antiques, collectibles or jewelry)
- Future paychecks
Some lenders might accept a retirement account if it’s in your name. However, borrowers can’t use an IRA because the Internal Revenue Service (IRS) usually prohibits the funds from being used for a loan’s collateral. You may also find it challenging to use a 401(k) since most employers control when and how often an employee withdraws funds.
Should You Use Collateral For A Loan?
While you might be hesitant to use your personal belongings as collateral, securing a loan can benefit you and your lender. Since a financial institution has more protection when offering a secured loan, the borrower can usually get a lower interest rate or longer loan term. Borrowers with poor credit scores may also have an easier time obtaining approval with a collateralized loan.
But keep in mind: If you default on a secured loan, you could lose whatever you put up for collateral. This could include an item of high value like your home, vehicle or the cash stored in a savings account. No matter what you use, it’s best to know you can pay back the loan within the terms specified by your lender.
If you struggle to make the monthly loan payments, you can contact your lender to discuss a possible deferment or new repayment plan. Most lending institutions don’t want to seize your property and would rather find a way for you to pay off the loan, even if it means renegotiating your terms.
Using collateral for a loan comes with risks, but it also allows you to find a lower interest rate or longer term. Lenders also enjoy the benefits of a more secured loan by having the option to recoup some of their losses if they sell the item you used.
But what if you don’t have an item with a high enough value for the amount of money you need to borrow? In this case, you might use an unsecured loan instead. To learn more about this type of financing, read about unsecured loans and their pros and cons, so you can determine if this option is better for your situation.
Ready to get a personal loan? Apply today!
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