Collateral is something that helps secure a loan or guarantee that you’ll repay as agreed. When you borrow money with collateral, you agree that your lender can take the asset you pledge and sell it. By doing so, the lender can recover any funds that you do not repay.
Collateral makes it possible to get large loans, and it improves your chances of getting approved if you’re having a hard time getting a loan. And when you pledge collateral, the lender takes less risk, which means that you're more likely to get a good rate for the loan. Learn more about how the process works.
How Collateral Works
Collateral is often required when the lender wants to reduce the chances of losing money. If you pledge an asset as collateral, which is often a home or car, your lender has the right to take action, assuming you stop making payments on the loan. If you fail to make a payment or many payments, the lender may take possession of the collateral, sell it, and use the sales proceeds to pay off the loan.
Contrast a collateral loan with an unsecured loan, where all a lender can do is ding your credit score or bring legal action against you.
Lenders would prefer that you repay loans according to the repayment schedule. Bringing legal action against you takes time and money, so taking collateral is a last resort. Lenders typically don't even want to deal with your collateral (they're not in the business of owning, renting, or selling houses), but that is often their best form of protection.
Types of Collateral
Any asset that your lender accepts as collateral, and meets the laws, can serve as collateral. In general, lenders prefer assets that are easy to value and turn into cash. For example, money in a savings account is great for collateral, because lenders know how much it's worth, and it's easy to collect. Some common forms of collateral are:
- Real estate (including equity in your home)
- Cash accounts
- Machinery and equipment
- Insurance policies
- Valuables and collectibles
- Future payments from customers, otherwise known as" receivables"
Even if you're getting a loan for your business, you might pledge personal assets (like your family home) as part of a personal guarantee.
Retirement accounts such as IRAs are often not allowed to serve as collateral, according to the IRS.
How Much Are Assets Worth?
Lenders typically offer less than the value of your pledged asset, and some assets might be heavily discounted. For example, a lender might only recognize 50% of your investment portfolio for a collateral loan. That way, they improve their chances of getting all their money back in case the investments lose value.
When applying for a loan, lenders often quote an acceptable loan-to-value ratio (LTV). For example, if you borrow against your house, lenders might allow an LTV up to 80%. In that case, if your home is worth $100,000, you could borrow up to $80,000.
If your pledged assets lose value for any reason, you might have to pledge additional assets to keep a collateral loan in place. Likewise, you are responsible for the full amount of your loan, even if the bank takes your assets and sells them for less than the amount you owe. If you do not comply, the bank can bring legal action against you to collect any deficiency (the amount that didn't get paid off).
Types of Loans
Several types of loans allow you to borrow against collateral, including business and personal loans. Because they don't have a long track record of operating at a profit, many new businesses are required to pledge collateral, such as personal items that belong to business owners.
In some cases, you get a loan, buy something, and pledge it as collateral all at the same time. For example, in premium-financed life insurance cases, the lender and insurer often work together to provide the policy and collateral loan at the same time.
A financed home purchase is similar: The house secures the loan, and the lender can foreclose on the home if you don't repay. Even if you're borrowing for fix-and-flip projects, lenders want to use your investment property as security. When borrowing for mobile or manufactured homes, the type of loan available will depend on the age of the home, the foundation system, and other factors.
There are also a variety of collateral loans for people with bad credit. These loans are often expensive and can make things go from bad to worse, so it’s best to avoid borrowing whenever possible. For example, car title loans allow you to borrow using your automobile as collateral. But be careful with these loans: If you fail to repay, your lender can take the vehicle and sell it—often without notifying you ahead of time.
Can You Borrow Without Collateral?
If you prefer not to pledge collateral, you’ll need to find a lender that’s willing to approve a loan based on your income and credit scores. Some of the options include:
- Unsecured loans from banks and credit unions, such as personal loans and credit cards.
- Online loans (including peer to peer loans), which are often unsecured loans.
- Getting a co-signer to apply for the loan with you, putting their credit at risk to help you get approved.
In some cases, like when buying a home, borrowing without using anything as collateral is probably not possible (unless you have significant equity in the home). In other situations, borrowing without collateral may leave you with fewer choices and more expensive options.
Frequently Asked Questions (FAQs)
Can collateral be used as a down payment on a house?
A down payment is usually 20% of the total home loan that you are expected to take on. You can use your current assets, like stocks, gold, and other property, to take out a loan to pay your down payment if you need to. You'll need to get your assets appraised first to know how much they'll be worth as collateral for the loan.
What can be used as collateral?
Lenders usually prefer assets that are easy to value and liquidate. Some lenders have specific rules for what assets they'll accept. Vehicles, real estate, future paychecks, jewelry, fine art, boats, stocks, antiques/collectibles, savings accounts, and certificates of deposit are usually acceptable forms of collateral.