What Is Collateral?

Collateral is an asset that a lender accepts as security for a loan. If the borrower defaults on the loan payments, the lender can seize the collateral and resell it to recoup the losses.

How Collateral Works

Loans that are secured by collateral are typically available at substantially lower interest rates than unsecured loans. The borrower has a compelling reason to repay the loan on time. If the borrower defaults, the lender can seize the property and sell it to recoup some or all of the losses.

A lender's claim to a borrower's collateral is called a lien.

[Important: If you are considering seeking a collateralized personal loan, your best choice is probably a financial institution that you already have an account with.]

The nature of the collateral is often predetermined by the loan type. For a home buyer, the house is the collateral for the mortgage. For a car buyer, the car is the collateral for the 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 interest rate offered will be more favorable than if the loan was not secured. The value of the collateral must meet or exceed the amount being loaned.

The types of collateral that are commonly accepted by lenders include cars (if they are paid off in full), bank savings deposits, and investment accounts. Retirement accounts are not usually accepted as collateral.

Future paychecks also can be used 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 are an option in a genuine emergency, though even then the potential borrower should read the fine print and compare rates.

If you are considering seeking a collateralized personal loan, your best choice is probably a financial institution that you already do business with, especially if your collateral is your savings account. The bank is more likely to green-light the loan, and you are more likely to get a decent rate for it.

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 up to $75,000.

Collateral in Margin Trading

Collateralized loans also are 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.

But 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.

Key Takeaways

  • Collateral is an item of value that is accepted as security for a loan.
  • Anyone who has had a home mortgage or a car loan has had a collateralized loan.
  • A collateralized personal loan can be obtained using other personal assets such as a savings account or an investment account.