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What is Collateral?

How Collateral Works

Types of Collateral

Exemples of Collateral Loans

Personal Finance Lending

Collateral Definition, Types, & Examples

By Julia Kagan

Updated September 25 2022

Reviewed by Amy Drury

The factual information was checked 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 a loan.

If a homeowner is able to obtain a mortgage, the house is used as collateral for the loan. For an automobile loan the vehicle serves as the collateral. Businesses that get finance from a bank can make a pledge of important equipment or real estate owned by the business to secure the loan.

A loan that is secured by collateral is characterized by a an interest rate that is lower than an unsecured loan. In the event of insolvency, the lending institution can take the collateral and then trade it for a profit to cover the loss.

The most important takeaways

Collateral is an item of value that can be pledged in order to help secure a loan.

Collateral reduces the risk for lenders.

If the borrower fails to pay the loan the lender may seize the collateral and trade it in to cover its losses.

The mortgage and the car loans are two types of collateralized loans.

Additional personal possessions, such as the savings or investment account, could be used to obtain a collateralized personal loan.

How Collateral Works

Before a lender gives you with a loan they want to ensure that you are able to pay back the loan. This is why a lot of loans require some type of security. The security is known as collateral which minimizes the risk for lenders. It is a way to ensure that the borrower keeps up with their financial obligations. If the borrower defaults the lender may take the collateral and then trade it in, transferring the money it gets to the portion that is not paid of the loan. The lender is able to take legal action against the borrower to recoup any balance remaining.

As mentioned above collateral can come in many forms. It usually relates with the type of loan, so a mortgage is collateralized by the house, whereas the collateral for automobile loan is the vehicle that is being used. Other nonspecific, personal loans may be secured by other assets. For example a secured credit card may be secured with a cash deposit for the same amount as the credit limit–$500 for a credit limit of $500.

Secured loans secured by collateral are usually offered at significantly lower rates of interest than unsecured loans. A lender’s claim on collateral belonging to a borrower is referred to as a lien. It is a legitimate right to claim an asset to satisfy the debt. The borrower must have a compelling reason to repay the loan promptly because if they default, they could lose their home or other property pledged as collateral.

Different types of collateral

The type of collateral is usually determined by the loan kind. When you take out a mortgage, your home becomes the collateral. If you take out an auto loan, then your car will be 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, bank savings deposits and investment accounts. Retirement accounts aren’t usually accepted as collateral.

It is also possible to use future paychecks as collateral for short-term loans that are not only through payday loan lenders. Traditional banks provide these loans generally with terms that are not more than a couple of weeks. These short-term loans can be a viable option in an emergency situation, but even then you must read the fine print carefully and compare rates.

Collateralized Personal Loans

Another type of loan is the collateralized personal loan where the borrower provides an item of value as security in exchange for a loan. The value of the collateral must equal or exceed the amount being loaned. If you’re thinking about a collateralized personal loan the best option for a lender is probably an institution you have already established a relationship with, especially if your security is your bank account. When you’ve already established a connection with your bank they is more likely to grant the loan and also likely to receive an affordable rate.

Use a financial institution with which you have a previous relationship when you’re looking at an uninvolved personal loan.

Exemples of Collateral Loans

Residential Mortgages

A mortgage is an loan where the house acts as the collateral. If the homeowner stops paying the mortgage for a minimum of 120 days and the loan servicer can begin legal proceedings which can lead to the lender eventually taking possession of the home by foreclosure.1 After the property has been handed over to the lender it is then sold to pay back the remaining principal on the loan.

Home Equity Loans

A home could also be used as collateral for the second mortgage or home equity line of credit (HELOC). In this case the amount of the loan is not greater than the available equity. For instance, if a home is valued at $200,000, and $125,000 remains on the primary mortgage A second mortgage or HELOC will be available only for a maximum of $75,000.

Margin Trading

Collateralized loans can also be a factor when it comes to margin trading. An investor borrows the money of a broker to buy shares, using the balance in the investor’s brokerage account to secure the loan. The loan increases the number of shares the buyer can purchase, thus increasing the gains that could be earned if the shares increase in value. However, the risk is multiplied. If the shares decrease in value, the broker demands payment for the loss. In this case the account acts as collateral in the event that the borrower does not cover the loss.