Written by: Eric Bank
Edited by: Austin Lang
Reviewed by: Jon McDonald
Let’s talk about collateral, the backbone of many financial deals. Think of collateral like the safety net under a tightrope walker — it’s there to catch the lender if the borrower takes a tumble and can’t repay the loan.
Collateral usually includes items of value, like your house or car, that back up the loan. If you don’t pay, the lender can swoop in and take that collateral to cover their losses.
Collateral is an asset or property that a borrower pledges as security for a loan. The lender has the right to seize the collateral if the debt is not repaid.
Collateral can be a wide range of things — from tangible stuff like real estate and vehicles to more intangible assets like stocks, bonds, and cold hard cash.
Typically, the worth of this collateral is equal to or higher than the loan amount. I’ll dive into the different aspects of collateral: how it works, why it’s a win-win for both sides, and what kinds of collateral are most commonly used in lending.
How Collateral Works
When your credit is less than brilliant, collateral can become your very best friend. It’s sort of a security blanket that makes the lender feel safe.
Collateral assures lenders will get their money back if something goes wrong and you can’t make the payments. It removes worry when you try to qualify for a loan.
Collateral Mitigates Risk for Lenders
Collateral reduces the lender’s risk because it offers them something of value should you go into default on the loan.
It’s like giving them the keys to your house: they know they can always take the structure if you are unable to uphold your end of the bargain. This added security oftentimes results in better terms on the loan, such as lower interest rates and fewer fees.
Collateral becomes even more critical when times are bad because lenders will be far more willing to stick their necks out if something valuable is already on the table.
Plus, it’s motivating for you as well. Knowing that your prized possessions are on the line is a powerful reason to stay on top of your payments. You’re less likely to miss a payment when you know your car, house, or other assets could be taken away.
This security blanket keeps the lending market stable, ensuring that even if some folks default, lenders can still recover their money and keep giving credit where credit is due.
It Can Improve Borrowing Opportunities
Put up some solid collateral, and you’re very likely to get a bigger loan on better terms. Lenders look upon it as a sign of commitment and financial stability, and perhaps that gets them to open the purse strings a little wider.
Many times, collateral is what seals a deal for big-ticket purchases like homes, cars, or business investments.
Putting up collateral may also help you get better interest rates and terms. That could mean plenty of savings over the life of a loan.
From the lender’s perspective, a collateral-backed loan is less risky, so they’re often willing to offer lower interest rates and longer repayment terms. Over the life of the loan, these savings can add up, making it easier to reach your financial goals.
Plus, when you pledge assets, you’re improving your chances of getting that loan approved.
Common Types of Collateral
Collateral comes in all shapes and sizes, and each type offers a different level of security for the lender. The most common types include real estate, vehicles, and financial assets, each playing a crucial role in various types of loans.
Homes for Mortgages
By far the most common collateral for a loan is the borrower’s house. A mortgage is self-collateralizing, meaning the property itself secures the loan.
In the event that you default, the lender has a right to foreclose on your house, sell it, and recover the amount of the loan.
That’s pretty scary, I know. That’s why it works. Borrowers don’t want to lose their homes, so they work extra hard and do all they can to ensure their loan is repaid.
Vehicles for Auto Financing
Very commonly, collateral can include cars, trucks, and motorcycles. When the payments cannot be met, the lender may reclaim the vehicle and sell it to recover the debt.
Most auto loans collateralize your vehicle until you pay off the loan. If you don’t owe anything on your vehicle, you can use it as collateral to back another loan.
Because the actual vehicle is used as collateral, such loans are often much easier to get and at lower interest rates. Nonetheless, the lender will usually perform a credit check before offering the loan.
Financial Assets for Credit and Loans
Collateral may also include stocks, bonds, and savings accounts. These financial assets are liquidated with ease, hence why they are rather attractive to lenders.
If you fail to pay your loan, the lender can seize these assets to recover the loan. This type of collateral is particularly well-suited for personal and business loans.
But one of the most popular types of collateral is a cash deposit for a secured credit card. These cards are suited to borrowers with bad credit, and the cash can be used by the issuer to cover any missed payments. The cardholder can earn their deposit back after a certain period, typically one year, of on-time payments.
How to Offer Collateral
When it comes to offering up collateral, you should take care that everything is done correctly. This is not something you try to rush through. You have to do it right to keep both you and the lender happy.
Valuation of Collateral
First, a lender is going to want to know the value of your collateral. That’s where an expert appraisal comes in.
If it’s real estate, they’ll want to know how much that property can fetch in today’s market, based on location, condition, and recent sales in and around the property. This is part of the reason selling a house is so complicated: mortgages are based on what the house appraises for, not the asking price. If those don’t match up for whatever reason, you’ll be left paying the difference.
For vehicles and most other items, lenders can refer to resources like the Kelley Blue Book, which evaluates automobile prices. You can look up the make, model, year, mileage, and condition of your vehicle to determine what your ride is worth.
For many money-related assets, it is even easier than that. The market value for stocks, bonds, and savings accounts can be looked up quickly and easily. Such information is a matter of public record.
Remember that a lender will also work with you to determine that your collateral doesn’t already have a lien against it somewhere else. If it is encumbered, you hold a title that has a lien or a legal claim against it.
That means you aren’t going to be able to use that as part of your collateral until that debt is settled and done away with. No double dipping!
Provide Legal Documentation
The paperwork for a collateralized loan is more complex and time-consuming compared to an unsecured loan. The agreement has all the hairy details of what the lender can do if you default on the loan.
Expect the lender to demand a mortgage deed or lien as part of the loan package. These instruments make it child’s play for the lender to swoop in and seize your property. I suggest you, with your lawyer, go through the agreement and make sure you understand all the terms.
Risks and Considerations for Borrowers
Pledging collateral is not without its risks. Of course, the biggest risk is losing the asset in the case of loan default. This can be a setback in your financial standing, and it drags down your credit score.
Your Asset Can Be Seized
If you miss a payment on a secured loan, the lender has the right to recover the pledged collateral. In layman’s terms, they can take your stuff.
For example, if you take out a car loan and you fail to meet the monthly payments, the creditor can repossess the car and sell it to cover the debt. This can be a hard pill to swallow, especially if the asset is something you rely on for your daily life or business.
In some cases, you might be able to stop or reverse foreclosure altogether. Consider contacting the lender to see if they will agree to do a loan modification or perhaps provide a temporary forbearance that will help you catch up.
State statutes may provide you with a period of redemption to reclaim your property by paying the lapsed amount, with interest and penalties, of course.
Foreclosure takes a bit longer and is a little more complicated. Not making mortgage payments will cause the loan servicer to send out a notice of default, kicking off the foreclosure process. What follows may be a lawsuit or the auctioning of your property. You can fight back with legal defenses, loan modifications, or bankruptcy, essentially pausing foreclosure until the court sorts things out.
Even if the property is auctioned off, should the sale price exceed what you owe, the excess must be returned to you. This is a bittersweet consolation for losing your home.
Negative Credit Score Impacts
Defaulting on a loan can take a big bite out of your credit score. The lender is going to report you to the big credit bureaus — Equifax, TransUnion, and Experian — and that will surely knock your score down a peg or two.
If you default on a loan, you risk losing more than just collateral — you could lose plenty of points on your credit score.
That black mark hangs over your credit report for seven years and makes it much harder to get loans or credit cards in the future. Things get worse if your collateral is repossessed or foreclosed because a credit report will show a default, which is definitely going to be a bad hit on your score.
Rebuilding your credit after a default takes time and effort, and you may have to depend on secured credit cards or even small, collateralized loans to start climbing back up.
Collateral Acts as a Guarantee for Loan Repayment
Collateral matters most when you are borrowing with bad credit. It provides security for the lender because no matter what, they will have some way to get their money back.
The idea is that if you pledge something of value — be it a home, vehicle, or other financial asset — then you’re showing the secured creditor that you mean business in making good on repaying the loan. That gesture of good faith gives them the confidence to approve your application.
But remember that pledging collateral is risky business. In the event of default, you may end up losing that valuable asset, and most importantly, your credit score will suffer a serious jolt. That is why careful financial planning and commitment to making timely loan repayments are essential parts of this business.
When you understand all the nitty-gritty details — how collateral works, the available types, and the process involved — you’ll be able to make a well-informed financial decision.
