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What is Collateral On A Loan And Do You Need One?

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updated: May 28, 2024

Collateral is an asset that a borrower pledges as security for a loan. If the borrower defaults on the loan, the lender can seize the collateral and sell it to recoup its losses. This reduces lenders' risk. A lender’s right to seize collateral is called a lien.

Examples of collateral include a home for a mortgage or a vehicle for a car loan. Personal assets, like savings or investment accounts, can also be used to secure a loan. The specific nature of the collateral often depends on the type of loan being taken out.

Importance of collateral in securing loans

Collateral plays an essential role in the loan process for both lenders and borrowers.

Risk reduction

Collateral provides lenders with a form of security and reduces the risk of lending money. If you default on your loan, the lender can seize the collateral to cover part (or all) of what would have been a loss.

Loan accessibility

If you can offer collateral, lenders may extend a larger loan amount or more favorable loan terms, such as a lower interest rate. Your willingness to put your assets at risk signals to lenders that you will be serious about repaying your debt.

Incentive to repay

Offering collateral provides a real incentive to repay your debt or risk losing assets you already have. You are less likely to walk away from an obligation that could cause additional financial pain.

Confidence building

Collateral may give lenders confidence to extend credit to you. If you don’t qualify for an unsecured loan—due to a poor credit history or lack of creditworthiness—collateral provides a pathway to credit extension.

Credit score impact

Indirectly, the use of collateral can help raise your credit score. If it helps you obtain a loan that you successfully pay off, your credit score will benefit—and, eventually, make you eligible for better loan terms.

How collateral works

Collateral can take the form of various assets, such as real estate, vehicles, savings accounts, or investment portfolios. The specific type of collateral required depends on the loan type and the lender’s policies. Here’s how collateral functions as part of the lending process.

Asset pledge

You pledge an asset as collateral when taking out a loan. When buying a house, for example, the house becomes collateral to guarantee your loan repayment.

Loan security

This collateral provides security for the lender, ensuring that if you default on the loan, the lender has something of value to recover losses. If you default on your mortgage, for example, the lender can take possession of the house.

Value assessment

The lender assesses the value of the collateral to determine the loan amount. For a home mortgage, the lender requires an appraisal to determine how much it will lend you to buy the house.

Loan terms

Loans with collateral often have better terms, such as lower interest rates, because they present less risk to the lender. If you could find a lender willing to finance your mortgage without a mortgage lien, essentially using the house as collateral, your interest rate and other terms would be much higher.

Default consequences

If you fail to repay the loan, the lender can seize the collateral and sell it to recoup the loan amount. With a mortgage or car loan, this is known as taking possession (or repossession) of the collateral or asset.

Pros and cons of collateralized loans

Collateralized loans, also known as secured loans, come with their own set of advantages and disadvantages.

Pros:

  • Easier approval
  • Lower interest rates
  • Potential for higher loan amounts
  • Paying off a secured loan can help build credit

Cons:

  • Risk of asset loss
  • Loan may have less flexibility
  • Potential to over-borrow

Types of collateral

Real estate

Real estate is one of the most common forms of collateral. Homes, land, and other property types can be used to secure a mortgage or other loan.

Vehicles

Cars, trucks, or boat loans typically require that the vehicle or boat being purchased serve as collateral for the loan. Vehicles or boats that are paid off in full can be pledged as collateral for another loan.

Savings accounts

Money in a savings account can be used as collateral, often for personal loans. The advantage over an unsecured loan is a lower interest rate or better terms.

Investment accounts

Stocks, bonds, or mutual funds can be held as collateral, though retirement accounts are typically not accepted.

Business equipment

For business loans, equipment or machinery can be used as collateral. Factors that affect value include the age and condition of the equipment (and how usable it might be to potential buyers).

Inventory

Businesses can also use their inventory as collateral for loans. This type of collateral, also known as inventory financing, tends to be riskier and, therefore, commands higher interest rates.

Accounts receivable

Businesses can pledge unpaid invoices or expected payments as collateral. Similar to inventory financing, invoice financing can result in higher fees than a traditional loan.

Insurance policies

Certain types of insurance policies with a cash value, such as whole life insurance, can be used as collateral. If you die or default before the loan is repaid, the lender will have the right to collect the remaining loan amount upon death.

Future paychecks

Future paychecks might be used as collateral for very short-term loans. This type of collateral is used not only by payday lenders but also by banks.

Types of loans that involve collateral

Mortgages

Mortgages are loans used for purchasing real estate; the property is also the collateral. The most common example is when you buy a home and use that home as collateral to secure the loan.

Auto loans

Auto loans are loans for buying vehicles; the vehicle is used as collateral. This is similar to using a house as collateral for a mortgage loan.

Secured personal loans

Secured personal loans require an asset as collateral, such as a savings account, certificate of deposit (CD), or other valuable items.

Home equity loans and lines of credit (HELOCs)

Home equity loans and HELOCs are based on the equity of the borrower’s home. You can borrow against the line of credit and only pay interest on the portion you use.

Business loans

Business loans are often secured by business assets, such as equipment, inventory, or accounts receivable.

Secured credit cards

Secured credit cards require a cash deposit, which serves as collateral and sets the credit limit. They are often used to establish or rebuild a credit score.

Alternatives to collateral

Below are some options to qualify for credit if you lack the collateral for a secured credit card, loan, or mortgage. Each option has its own qualifications and terms; it’s important to research and compare them to find the best fit for your financial situation.

Unsecured personal loans

Unsecured personal loans don’t require collateral and are based on the borrower’s creditworthiness. The downside is that your interest rate and terms may be higher (less favorable) because the lender is taking on more risk. Note: Online lender Upstart uses AI to qualify applicants and claims to achieve 36% lower interest rates for approved borrowers.

Obtain a guarantor or co-signer

A guarantor or co-signer is a third party—usually with good credit—who guarantees to repay the loan if you can’t. In a way, that person is putting themself up as collateral on your behalf.

If you lack collateral and are struggling to qualify for an unsecured loan on your own, you might want to consider asking a parent or other close family member to co-sign or guarantee your loan. Proceed with caution, however; this arrangement can place strain on a relationship if the loan turns sour.

Peer-to-peer lending

Peer-to-peer (P2P) lending refers to a method of borrowing from individuals through online platforms. P2P lending may not require collateral. As with most unsecured loans, P2P loans typically have higher interest rates, though not necessarily as high as a loan from a bank or other financial institution.

Credit unions

Credit unions may offer membership-based loans without collateral. These unsecured loans may have higher rates than secured loans (but lower rates than credit cards).

Microcredit loans

Microcredit lenders provide small loans to individuals or groups who lack access to traditional banking systems. Microcredit loans do not require collateral. Microcredit is not the same as microfinance, a type of small loan that does require collateral.

Government-backed loans

Some government loans, such as SBA 7(a) Small loans of $50,000 or less, do not require collateral. They do, however, require an unlimited full guaranty from any individual who owns 20% or more of the borrowing entity.

TIME Stamp: Know how and when to use collateral to secure a loan

Secured or collateralized loans feature easier approval, lower interest rates, and access to more credit. Downsides include potential asset loss, stricter terms, and possible credit damage if you default. Know your financial situation; if you are sure of your ability to repay, collateral can provide less expensive access to loan funds in almost all cases.

Frequently asked questions (FAQs)

Can I use collateral to secure any type of loan?

Collateral can be used to secure different types of loans, such as personal loans, business loans, and mortgage loans. However, the type of collateral accepted may vary depending on the lender and the type of loan. For instance, a car may be used as collateral for a personal loan, while a business may use its inventory or equipment as collateral for a business loan.

What happens to collateral after loan repayment?

Once a loan is fully repaid, the collateral used to secure the loan is typically returned to the borrower. For instance, if a person uses their car as collateral for a personal loan and repays the loan in full, the lender will release the lien on the car and return the title to the borrower.

Can I add collateral to an existing loan?

In some cases, you can add collateral to an existing loan, but this will depend on the terms of your loan agreement (and your lender’s policies). If you want to add collateral to an existing loan, you should contact your lender to discuss your options and determine if this is possible.

Do I get back my collateral?

If you have pledged collateral as security for a loan, and you’ve made all of your payments according to the loan agreement, you should get your collateral back once the loan has been fully paid off.

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