What Is Collateral?
How Collateral Works
Different types of collateral
Examples of Collateral Loans
Personal Finance Lending
Collateral Definition, Types, & Examples
By Julia Kagan
Updated September 25, 2022
Review by Amy Drury
Checked for accuracy by Ryan Eichler
Collateral
Investopedia / Zoe Hansen
What is Collateral?
In the world of finance, collateral is a valuable asset that a borrower pledges as security for the loan.
When a homeowner gets an mortgage, the property acts as the security for the loan. When it comes to the car loan the car is the collateral. Businesses that get funding from a lender may make a pledge of valuable equipment or real estate owned by the business as collateral for the loan.
A loan which is secured with collateral comes with the lowest interest rate than an unsecure loan. If there is a failure to pay, the loaner could confiscate the collateral and trade it for a profit to cover the loss.
Key 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 a borrower defaults on the loan, the lender can seize the collateral and sell it to recoup its loss.
Car loans are two kinds of collateralized loans.
Personal assets like such as an investment or savings account, are able to be used to obtain the collateralized personal loan.
How Collateral Works
Before a lender gives you with a loan the lender wants to ensure that you’re able to pay back the loan. This is why a lot of loans require some sort of security. This is referred to as collateral that reduces the chance for lending. It helps to ensure that the borrower stays on track with their financial obligation. If the borrower defaults, the lender can confiscate the collateral and sell it, applying the money it gets to the remaining balance that is due to the loan. The lender may decide to pursue legal action against the borrower to recoup any balance remaining.
As we mentioned earlier, collateral can take many forms. It is usually related to the nature of the loan, so the mortgage is secured by the home, and the collateral for vehicle loan is the vehicle the loan is secured by. Other nonspecific, personal loans can be collateralized by other assets. For instance the 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 offered at lower interest rates than unsecure loans. A lender’s claim to collateral belonging to a borrower is referred to as a lien–a legitimate right to claim an asset to settle the obligation. The borrower has an incentive to pay back the loan on time since if they fail to pay, they could lose their home or any other asset that are pledged as collateral.
Types of Collateral
The character of the collateral is often predetermined by the loan kind. If you get an mortgage, your home is the collateral. If you are taking out a car loan, then the car is 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 investments accounts. Retirement accounts are not usually considered collateral.
You can also use future paychecks as collateral for very short-term loans, and not just by payday lending companies. Traditional banks offer such loans, usually for terms of no more than a few weeks. These short-term loans can be used in an emergency situation, but even then, you should take note of the fine print and check rates.
Collateralized Personal Loans
Another form of loan is the collateralized personal loan that is where the borrower pledges something of value as security for the loan. The collateral’s value must equal or exceed the amount of money being borrowed. If you’re thinking about a personal collateralized loan, your best choice for a lender is likely an institution you already have a relationship with, especially if your security is your bank account. In the event that you have an existing relationship with the bank, the institution would be more inclined to approve the loan and you’re likely to receive an affordable rate.
Choose a bank with which you have already established a relationship when you’re looking at the collateralization of a personal loan.
Illustrations for Collateral Loans
Residential Mortgages
A mortgage is a loan where the house acts as the collateral. If the homeowner fails to pay the mortgage for a minimum of 120 days and the loan servicer could initiate legal proceedings which can lead to the lender eventually getting possession of the property by foreclosure.1 Once the property is handed over to the lender, it can be transferred to the lender in order to pay the remainder of the principal loan.
Home Equity Loans
A home can also serve as collateral for an additional loan, such as a mortgage or home equity line (HELOC). In this instance, you can guarantee that your loan is not greater than the available equity. For example, if a home is valued at $200,000, and $125,000 remains in the primary mortgage, a second mortgage or HELOC can be obtained for as much as $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 purchase shares. The broker uses the balance of the investor’s broker account for collateral. The loan can increase the number of shares the investor can buy, thus multiplying the potential gains should the shares appreciate in value. However, the risks are multiplied. If the shares fall from value to the point that the broker will demand the amount for the loss. In this case the account acts as collateral if the lender does not cover the cost.
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Related Terms
Non-Recourse Debt: Definition, Example, vs. Recourse Debt
A non-recourse loan is a kind of loan that is secured by collateral, usually property, and the lender is at greater risk if the borrower defaults in the loan.
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Signature Loan
The signature loan is a personal loan provided by banks as well as other finance companies. It relies only on the signature of the borrower and commitment to pay collateral.
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Collateralization Definition, What It Is, How It Works Examples
Collateralization is the use an asset that is valuable in order to ensure the loan against default. The collateral is able to be taken by the lender in order to compensate any loss.
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Line of Credit (LOC) Definition Types, Examples, and Definitions
An LOC or line of Credit (LOC) can be described as an agreement between an institution and a client which establishes a predetermined borrowing limit that can be used frequently.
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Prior Lien
A prior lien is a lien in which the lien is recorded prior to any other claim.
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Unsecured Loan
An unsecured loan does not require any kind of collateral, however to get an approval for one, you’ll need good credit.
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