Collateral is a property or other asset that a borrower offers as a way for a lender to secure the loan. If the borrower stops making the promised loan payments, the lender can seize the collateral to recoup its losses. Since collateral offers some security to the lender should the borrower fail to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans. A lender's claim to a borrower's collateral is called a lien.
The type of collateral for a loan may be predetermined based on the loan type, such as with a mortgage or an auto loan, or may be flexible, such as a collateralized personal loan. For a loan to be considered secure, the value of the collateral must meet or exceed the amount remaining on loan.
Secured loans are less risky to lenders since the property gives the borrower a compelling reason to continue payment. If a borrower fails to make necessary payments, the lending institution can repossess the property to cover the remainder of the loan.
For a mortgage, the collateral is the house purchased with the funds from the mortgage. If payments on the debt cease, the lender can take possession of the house through a process called foreclosure. Once the property is in the lender’s possession, the lender can sell the property to get back the remaining principal on the prior loan.
A home may also function as collateral on a second mortgage or a home equity line of credit (HELOC). In these instances, the amount provided as credit does not exceed the available equity in the home. For example, if a home is valued at $200,000, and $125,000 remains on the primary mortgage, most second mortgages or HELOCs are not available in amounts above the remaining equity of $75,000.
In margin trading, the securities in your brokerage account act as collateral in case of a margin call. Similar to the security offered by loan collateral in the event a borrower becomes unable to make payments, the value of the securities functions as assurance that the institution can recover funds.
When you borrow money with a credit card, there is no collateral. To compensate for the additional risk associated with default, credit card debt often carries a significantly higher interest rate than mortgage or auto loan debt.