Collateral is something like a property or an asset that holds value and that you provide to a lender to secure a loan.
Lenders, always looking to limit their risk, ask for collateral as a security measure to help ensure you’ll pay the money back. They know, if you default on the loan, they can likely take possession of the collateral as their loan payment.
If you’re considering getting a loan secured by a personal asset as collateral, it’s important to understand how collateral works, how you might encounter it and how it may benefit you.
How Does Collateral Work?
When a loan is collateralized, borrowers are incentivized to repay the loan on time. That’s because if they default on the loan, they could lose their home or car or whatever asset they pledge to the loan as collateral.
Collateralized loans, which are commonly called secured loans, are generally safer than unsecured loans, which are not backed by collateral. For that reason, secured loans are typically easier to obtain and come with lower interest rates than unsecured loans.
Banks use the loan-to-value (LTV) ratio to calculate how much collateral they will require for a loan. Typically, lenders do not want to lend more than 80% LTV (80% of the value of the collateral). For example, if you offer up jewelry valued at $100,000, a lender may accept it as collateral to borrow $80,000.
Typically, collateral is considered acceptable so long as the lender can seize the financial asset and sell it for cash, but different loan types have different requirements. For example, home mortgages are secured by the home itself. With personal loans, jewelry, antiques or art are common forms of acceptable collateral while business loans may require equipment or inventory as collateral.
The obvious downside to using collateral is that the lender can take possession of it if you are unable to pay on a secured loan. If you miss payments on your auto loan, the lender may be able to repossess your car, possibly without warning or court proceedings. The consequence is equally serious for home loans, with lenders taking ownership of homes when the borrowers default on the loan.
Types of Loans That Require Collateral
When it comes to securing a loan, the type of collateral is often predetermined by the loan type
Here are the most common types of secured loans and the collateral needed to obtain the loan:
- Mortgages – The real estate you buy is usually the collateral. The same is true if you get a HELOC or home equity loan.
- Auto Loans – The vehicle itself serves as the collateral
- Secured Credit Cards – These credit cards can be beneficial for those with unestablished or poor credit. Secured credit cards require a deposit that will be the same amount as your line of credit once you are approved. The deposit serves as the collateral; if you don’t pay off your balance as agreed, you can lose the deposit.
- Personal Loans – The most common reason that consumers take out personal loans are to consolidate existing debt or to renovate their home. These loans can be secured and unsecured. If you get a secured personal loan, you can usually use your home, car, savings, investments or even future paychecks as collateral.
- Small Business Loans – Business owners looking to grow their business often use loans to finance office space, equipment or to hire new staff members. Business loans typically require collateral in the form of real estate, equipment inventory or future customer payments. You may be able to use personal assets as loan collateral, particularly if you’re running a home business.
How Collateral Benefits You
While you may not like pledging collateral to get a loan, it could be worth it so long as you make timely payments.
When you secure a loan with collateral, lenders will often offer a lower annual percentage rate (APR) than they would for an unsecured loan, with the exceptions of mortgage and auto loans. A lower interest rate means you could save money with a lower total loan cost.
Collateral may indirectly help consumers build a credit history when it is used to secure a loan that is repaid on time. However, you may not want to get a secured loan solely for your credit, as the risk of losing your collateral is real. This is particularly true if your budget doesn’t have much room for another payment.
The Bottom Line
Collateral is a borrower’s pledge of property or assets to a lender, to secure a loan if the borrower is unable to make loan payments. The primary benefit to you as a borrower is that it makes loans easier to obtain and usually comes with lower interest rates than unsecured loans. Conversely, the clear downside to offering up collateral is that you can lose it in the event you are unable to make payments.
If you’re concerned about pledging collateral, you may want to consider getting an unsecured loan. Without an asset the lender can seize, the interest rate with unsecured debt will usually be higher. You’ll likely need strong credit or a cosigner as the lending requirements for unsecured debt may be tougher than for secured debt.