What is Collateral and How does it Work?
Collateral is something that helps secure a loan. When you borrow money, you agree (somewhere in the fine print) that your lender can take something and sell it to get their money back if you fail to repay the loan. 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.
When you pledge collateral, the lender takes less risk, which means you're more likely to get a good rate.
How Collateral Works
Collateral is often required when the lender wants some assurance that they won’t lose all of their money. If you pledge an asset as collateral, your lender has the right to take action (assuming you stop making payments on the loan): they 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 or bring legal action against you.
Lenders would prefer, above all else, to get their money back. They don't want to bring legal action against you, so they try to use collateral as a safeguard. They don't even want to deal with your collateral (they're not in the business of owning, renting, and selling houses), but that is often the easiest form of protection.
Types of Collateral
Any asset that your lender accepts as collateral (and which is allowed by law) 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: lenders know how much it's worth, and it's easy to collect. Some common forms of collateral include:
- Real estate (including equity in your home)
- Cash accounts (retirement accounts typically don't qualify, although there are always exceptions)
- Machinery and equipment
- Insurance policies
- Valuables and collectibles
- Future payments from customers (receivables)
Even if you're getting a business loan, you might pledge your personal assets (like your family home) as part of a personal guarantee.
Note that retirement accounts such as IRAs are often not allowed to serve as collateral.
Valuing your Assets
In general, the lender will offer you less than the value of your pledged asset. 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%. If your home is worth $100,000, you can 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. The bank can bring legal action against you to collect any deficiency (the amount that didn't get paid off).
Types of Loans
You may find collateral loans in a variety of places. They are commonly used for business loans as well as personal loans. Many new businesses, because they don't have a long track-record of operating at a profit, are required to pledge collateral (including 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 some collateral loans for people with bad credit. These loans are often expensive and should only be used as a last resort. They go by a variety of names, such as car title loans, and generally involve using your automobile as collateral. 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.
Borrowing Without Collateral
If you prefer not to pledge collateral, you’ll need to find a lender that’s willing to hand over money based on your signature (or somebody else’s signature). Some of the options include:
- Unsecured loans such as personal loans and credit cards
- Online loans (including peer to peer loans) are often unsecured loans with good rates
- Getting a cosigner to apply for the loan with you – putting their credit at risk
In some cases, like buying a home, borrowing without using anything as collateral is probably not possible (unless you have significant equity in the home). In other situations, it might be an option to do without collateral, but you'll have fewer choices and you have to pay a higher rate to borrow.