What Is Collateral?

Collateral is an asset that a lender accepts as security for extending a loan. If the borrower defaults on her loan payments, the lender may seize the collateral and sell it to recoup some or all of his losses. Collateral can take the form of real estate or other kinds of assets, depending on what the loan is used for.

How Collateral Works

Loans that are secured by collateral are typically available at substantially lower interest rates than unsecured loans. A lender's claim to a borrower's collateral is called a lien. The borrower has a compelling reason to repay the loan on time because if she defaults on it, then she stands to lose her home or whatever other assets she has pledged as collateral.

If you're considering a collateralized personal loan, it's wise to use a financial institution with which you already have a relationship.

Types of Collateral

The nature of the collateral is often predetermined by the loan type. When you take out a mortgage, your home becomes the collateral. If you take out a car loan, then the car is the collateral for the loan. The types of collateral that lenders commonly accept include cars (if they are paid off in full), bank savings deposits, and investment accounts. Retirement accounts are not usually accepted as collateral.

You also may use future paychecks as collateral for very short-term loans, and not just from the notorious payday lenders. Traditional banks offer such loans, usually for terms no longer than a couple of weeks. These short-term loans are an option in a genuine emergency, but even then, you as a potential borrower, should read the fine print carefully and compare rates.

The Collateralized Personal Loan

Another type of borrowing is the collateralized personal loan, in which the borrower offers an item of value as security for a loan. The value of the collateral must meet or exceed the amount being loaned.

If you are considering applying for a collateralized personal loan, your best choice for a lender is probably a financial institution that you already do business with, especially if your collateral is your savings account. If you already have a relationship with the bank, that bank would be more inclined to approve the loan, and you are more apt to get a decent rate for it.

Key Takeaways

  • Collateral is an item of value that is accepted as security for a loan.
  • Anyone who has taken a home mortgage or a car loan has received a collateralized loan.
  • You may use other personal assets, such as a savings or investment account, to secure a collateralized personal loan.

Examples of Collateral Loans

A mortgage is a loan in which the house is the collateral. If the homeowner stops paying the mortgage, the lender can take possession of the house through foreclosure. Once the property is transferred to the lender, it can be sold to repay the remaining principal on the loan.

Collateral in Home Equity Loans

A home may also function as collateral on a second mortgage or home equity line of credit (HELOC). In this case, the amount of the loan will not exceed the available equity. For example, 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 as much as $75,000.

Collateral in Finance: Margin Trading

Collateralized loans are also a factor in margin trading. An investor borrows money from a broker to buy shares, using the balance in the investor's brokerage account as collateral. The loan increases the number of shares that the investor can buy, thus multiplying the potential gains if the shares increase in value.

However, in margin trading, the risks are also multiplied. If the shares decrease in value, the broker demands payment of the difference. In that case, the account serves as collateral if the borrower fails to cover the loss.