What is Collateral?
Collateral is an asset a borrower owns that they agree to give to their lending institution if they default on their loan.
Lending money is always a risk for a financial institution. Many lenders want a guarantee that if a borrower stops making payments on a loan, they’ll be able to recover their money. A loan that’s backed by collateral is a secured loan (because it offers security for the lender). Some loans come with collateral built-in. If you take out a loan for a car or a house, that asset is the collateral on that loan. In other situations, such as with a personal loan, a lender might ask that you put up collateral to get approved or receive lower interest rates.
Imagine Tom is taking out a car loan from his local credit union. In exchange for the money to buy the car, the credit union asks that Tom put his new car up as collateral. That means if Tom stops making his car payments in the future, his bank can take the car to try to get back the money they lent Tom.
Collateral is like an insurance policy for a lender…
In a perfect world, all borrowers would make their monthly payments on time. And just like you hope you never have to use your insurance for an emergency, your lender hopes they don’t have to seize your collateral. But at least they know it’s there to help reduce their losses if they need it.
Anytime a bank or financial institution lends someone money, they’re taking a risk that the borrower might stop paying on the loan. To help reduce this liability, a lender might ask that you put up some form of collateral to borrow money.
When you have a collateral-backed loan, your lender has a claim (aka lien) on your asset. If, at some point, you stop making payments on your debt, the lender has the contractual right to take your asset. The collateral serves both as a way for lenders to hedge their risks, and as a sort of incentive for the borrower to keep making their payments.
There are also situations where your lender doesn’t require you to put up collateral, but you might be able to get a better loan if you make the offer. Consider the example of unsecured loans like many personal loans, student loans, and small business loans. If the borrower stops paying on those, there’s no collateral built into the agreement for the lender to seize. After all, your lender can’t take your college degree if you stop paying on your student loans.
For those loans that don’t necessarily require collateral, the lender might offer you a lower interest rate, a longer term, or a higher amount if you agree to put up assets equal to the value of the loan.
There are several examples of loans that are inherently secured loans (meaning they’re backed by collateral). One example of this type of loan is a mortgage — This is almost always a secured loan. When you borrow money to buy a house, you agree to put the house up as collateral. If you stop paying on your loan, the lender can seize your home through the process of foreclosure.
Another example of a collateral-backed loan is an auto loan, which is usually backed by the car you’re purchasing. If you stop making your car payment, the lender can take possession of your vehicle.
There are less common loans that are also collateral-backed. Some homeowners choose to take out a home equity line of credit (aka a HELOC). It lets you use the value of your home as collateral to borrow money. The catch with a HELOC is that if you already have a mortgage on your home, you can only borrow against the portion of your home you’ve built up in equity. So if your house is worth $200,000, but you only have $50,000 in equity (meaning you still owe the bank $150,000 on the house), then you can only take a home equity loan for up to $50,000.
Finally, collateral plays a role in the investing world in the form of margin trading. That’s when an investor borrows money from a broker to buy securities (aka buying on margin). To buy on margin, The investor has to have a balance in their brokerage account to use as collateral. The advantage of borrowing from the broker is that an investor can buy more shares. But if the price of the share decreases and the investor loses the money they borrowed, they have to raise funds somehow to pay back the loan.
You can use just about anything of value as collateral for a loan. For some types of loans, such as a mortgage, car loan, or home equity loan, the collateral is already decided. But with other types of debt (like a personal loan), you can put up something else of value that is worth enough to cover the cost of the loan.
Some examples of collateral that you might be able to use are your house, car, investments (like stocks and bonds), or even valuable jewelry. Lenders tend to prefer collateral that’s liquid, meaning things they can turn into cash more easily.
There is a catch, though. You can only use things that you own as collateral. So if you own your car outright, you can use it as collateral for a personal loan. But if you still have an auto loan that uses your car as collateral, you can’t use that same car as the collateral for a different loan. Lenders want to know that if you default on all of your debts, they’ll still have a good chance of getting their money back.
There are also some assets that you’re not allowed to use as collateral at all. Per IRS rules, you can’t use the money in your 401(k) plan or individual retirement account (IRA) as collateral. There is a way around this restriction by borrowing directly against your 401(k) plan. Be aware that this is generally not advisable, as you could end up paying some hefty taxes or fees, and be accountable for the remaining loan balance if you leave your job.
As a borrower, it might seem both inconvenient and intimidating to put up collateral for a loan. After all, what if you can’t afford to make your monthly payments, and the lender seizes your collateral? While that’s certainly a possibility, there are some advantages for you as well.
Secured loans often come with a lower interest rate than unsecured loans (those without collateral). You can assume that the more risk a lender takes on by lending you money, the higher your interest rate is going to be. So when you offer collateral as a form of security, they’re likely to give you a lower interest rate.
Consider the difference in the average interest rate between two popular types of loans. Auto loans are typically secured loans because the car you’re buying is the collateral. The national average for a car loan in 2019 was 4.21%. A personal loan, on the other hand, is often unsecured. The average rates for this type of loan ranged from 10% to 28% in 2019. But keep in mind, the 10% rate was only available to those with excellent credit. With the national average credit score being around 703, most people would only have access to an interest rate of 13.5% to 15.5%.
Another advantage of collateral-backed loans is that they provide the opportunity to build credit for people who wouldn’t normally qualify for a regular loan or credit card. One way financial institutions do this is by offering secured credit cards. Unlike a regular unsecured credit card, a secured credit card requires you to deposit money before you start charging.
You make monthly payments as you would on a regular credit card, but the company holds your cash in case you don’t pay them back. After a certain period of time, you may be able to upgrade to an unsecured credit card and get your cash back. The purpose of a secured credit card is to help those with poor credit build up their creditworthiness so they can be eligible for other types of loans and credit in the future.
Despite the potential savings they provide, collateral-backed loans do pose some inherent risks. If you can’t afford to make the payments at some point, you risk losing the associated asset like your car or even your home. Think carefully before using anything as collateral that you can’t afford to lose.
The other potential problem with collateral-backed loans is that they’re only available to those that have a valuable asset to use. For someone with low income and few assets, getting a loan of any kind might be a huge struggle.
What is Debt?
What is a Security?
What is Interest?
What is an Interest Rate?
What is a Broker?
What is an Individual Retirement Account (IRA)?
What is a 401(k) Plan?
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