Collateral represents something you own, of value, that you offer to a lender as security in return for a loan. If you fail to pay the loan, the lender can legally claim your collateral as part of its effort to recover at least some of the amount you borrowed.
This article will take a look at collateral, what you can use as collateral and how collateral can help you when you borrow money.
What Is Collateral?
Collateral represents some type of property that you own that you offer as security in order to obtain a loan. The item you offer should have value, and it is something the lender can repossess if you don’t make payments. With collateral, you reduce the risk the lender takes on because it can use the security you provide to recoup some of the money lent if you default.
- Alternative name: Sometimes, collateral is referred to colloquially as “skin in the game,” as it represents a borrower’s willingness to offer something valuable to guarantee the loan.
How Collateral Works
Collateral works as a way for borrowers to show they are committed to repaying their debt. The idea is that a borrower who has something important they might lose is more likely to make an effort to repay the loan. At the same time, the lender ends up taking on a lower degree of risk.
Because a lender has the legal right to take and use the collateral object of value, it can recover at least some of the money extended, in the event that you default.
In general, the collateral you provide must have enough value to allow for some degree of recovery for the lender. For example, a lender might not consider an item worth $1,000 sufficient value to be collateral for a loan of $100,000 or more.
Types of Collateral
When using collateral, the lender might accept different types of property as a type of guarantee against your loan. Some of the most common types of collateral include:
- Real estate: Property that you own, including a home, land, or business property, can be used as collateral.
- Vehicle: Your equity in your car or other vehicles can be used as collateral on certain loans. The lender usually holds the borrower’s vehicle title until the loan is paid off.
- Jewelry or other valuable items: If you have valuable possessions, such as fine jewelry or a designer handbag, you might be able to use them as collateral for a smaller loan.
- Cash: A cash account can also be used as collateral. For example, you might put a smaller amount of cash into an account to secure a larger loan. In some cases, you might have a bank that will allow you to take out a loan, as long as your cash accounts at that same institution are used as collateral.
- Investments: Occasionally, a lender will accept the assets in an investment portfolio to secure your loan.
- Inventory: If you own a business, any inventory you have might be acceptable as collateral for a loan.
Examples of Collateral Loans
One of the most common examples of a collateral loan is a mortgage. When you buy a home, it is used to secure the mortgage. If you don’t make your payments, the lender can foreclose on your home and you could lose the house because the lender will repossess and sell the home to recoup some of the money it gave you.
Another example of a collateral loan is an auto loan. When you get a loan to buy a car, the lender can repossess the vehicle if you miss payments.
Car title loans are a type of collateral loan because you promise the lender it can take your car if you don’t repay the amount borrowed.
Pawnshops also offer collateral loans. You bring in a valuable item, it’s appraised and the pawnshop owner acts as a lender, advancing the funds. If you repay the loan, you receive your item back. If you don’t repay the loan, you lose the item and the pawnshop owner can sell it to try to get back the amount lent.
Even secured credit cards are collateral loans. For example, if you get the Secured Mastercard from Capital One and make a $49 deposit, you can get a credit line of $200. If you default, Capital One will keep your deposit.
Pros and Cons of Collateral Loans
You might be able to get a loan even with poor credit.
In some cases, you might be able to get a larger loan.
Some collateral loans come with lower interest rates than unsecured loans.
There’s a possibility you could lose your valuable property if you default on the loan.
Depending on the type of loan, you might be restricted by what you can use the funds for.
Unsecured loans that don't require any collateral are sometimes an option when borrowing, but as the lender takes on more risk, that generally translates to higher interest rates and less favorable loan terms. You may find that putting an asset down as collateral is more beneficial than the extra money you'll pay in interest.
- Collateral is a valuable item that you own that you can use to secure a loan.
- With collateral, you might be able to get a lower interest rate or qualify for a loan even if you have poor credit.
- It’s important to understand that there is a chance you could lose the asset or piece of property put up as collateral if you default on your loan.