Collateral is an asset that lenders accept as security for a loan. It minimizes the risk for lenders and can take the form of real estate or another asset depending on the purpose of the loan. If a borrower defaults on their loan payments, the lender can seize the collateral and sell it to regain some or all of its losses. Collateral is a huge benefit to lenders and borrowers. Lenders gain more confidence, and borrowers can score lower interest rates.
How Collateral Works?
Before lenders give you a loan, they want to ensure that you can repay it. This is why many of them require some form of security. It helps ensure that borrowers stick to their financial obligation.
Collateral typically applies to the nature of a loan. So a mortgage would be collateralized by the home, while the collateral for a car loan is the vehicle in question. Other nonspecific, personal loans can be collateralized by other assets too. For example, a secured credit card may be secured by a cash deposit for the same amount of the credit limit ($500 for a $500 credit limit).
Loans secured by collateral are generally available at lower interest rates than unsecured loans. A lender’s claim to a borrower’s collateral is a lien (a legal right or claim against an asset to satisfy a debt). Borrowers have a convincing reason to repay the loan on time. If they default, they could lose their home or other assets pledged as collateral.
What are the Collateral Types?
The nature of the collateral is often pre-established by the loan type. When you take out a mortgage, your home becomes collateral. If you take out a car loan, then the car becomes collateral for the loan. Lenders often accept cars (only if they are paid off in full), bank savings deposits, and investment accounts. Retirement accounts are hardly ever accepted as collateral.
Future paychecks as collateral are options for very short-term loans, and not just from payday lenders. Traditional banks offer these kinds of loans for terms no longer than a couple of weeks. These short-term loans are an option for emergencies, but even in these scenarios, you have to read the fine print carefully and compare rates.
Collateralized Personal Loans
Collateralized personal loans are another way of borrowing money. Borrowers offer an item of value as security for a loan. The collateral’s value must meet or exceed the amount being loaned. If you are considering a collateralized personal loan, your best option for a lender is probably a financial institution that you already use for business. Particularly if your collateral is your savings account. If you have an established relationship with the bank, that bank would be more willing to approve the loan, and you are more likely to get a decent rate for it.
What are the Examples of Collateral Loans?
Examples of collateral loans are:
- Residential Mortgages
- Home Equity Loans
- Margin Trading
For each different type of loan, there is something of financial value that can be used to secure the loan. A house can serve as a form of collateral when you take out a mortgage or car loan, but it can go back to the lender if you do not hold up your end of the bargain under the repayment term.
A residential mortgage is a loan in which the house is the collateral. Suppose the homeowner stops paying the mortgage for at least 120 days. That means the loan servicer can start legal proceedings, which leads to the lender taking possession of the house through foreclosure. Once the property is passed on to the lender, it can be sold to replenish the remaining principal on the loan.
Home Equity Loans
A home can serve as collateral on a second mortgage or home equity line of credit (HELOC). In this instance, the amount of the loan will not exceed the available equity. Suppose a home is valued at $200,000, and $125,000 remains on the primary mortgage. This means a second mortgage or HELOC will be available only for as much as $75,000.
Collateralized loans are a factor in margin trading. An investor borrows money from a broker to purchase shares, using the balance in the investor’s brokerage account as collateral. The loan increases the number of shares the investor can buy, which multiplies the potential gains of the shares’ increase in value. However, the risks are multiplied. If the shares decrease in value, the broker requires payment of the difference. In that situation, the account serves as collateral if the borrower fails to cover the loss.