What is Collateral and How Do Collateral Loans Work?

The term "collateral" refers to any asset or property that a consumer promises to a lender as backup in exchange for a loan. Typically, collateral loan agreements let the lender take over the asset if the borrowers fail to repay the debt according to the contract. If you're considering taking on a loan secured by a personal asset, it's important to understand how collateral works.

Definition of Collateral

Collateral is something you own that the bank can take if you fail to pay off your debt or loan. This can be any item of value that is accepted as an alternate form of repayment in case of default. If loan payments are not made, assets can be seized and sold by banks. This ensures that a lender receives full or partial compensation for any outstanding balance on a defaulted debt. Loans with pledged collateral are known as "secured loans," and are often required for most consumer loans.

What is Collateral?

  • Item of value pledged by a borrower to secure a loan
  • Backup for loan repayment that adds security for a lender
  • Asset that a bank can seize and sell if a borrower defaults on their debt

Most financial assets that can be seized and sold for cash are considered acceptable collateral, although each type of loan has different requirements. For a standard mortgage or auto loan, the home or car itself is used as collateral. With high-value personal loans, valuable possessions like jewelry or paintings are also accepted. When companies and small businesses apply for loans, they often put up equipment or other physical assets as collateral.

For borrowers with poor credit, pledging a collateral asset can improve the chances of getting approved for a loan. Collateral demonstrates a consumer's commitment to repaying the loan and lowers the risk of loss to the lender. Loans secured with collateral also tend to have lower interest rates, which can save thousands of dollars in the long term. However, other factors like credit score, income and job stability will also influence your loan approval chances and interest rate.

Examples of Collateral Loans

Collateral requirements are a common feature of loans for both individuals and businesses. We outlined some consumer loan products to showcase the most popular examples of collateral.

Personal Loans

Personal loans are used by consumers to consolidate existing debt, build credit or finance everyday expenses. These loans are offered by lenders in two main types: secured and unsecured. Secured personal loans are backed by collateral, while unsecured loans are not. Because collateral reduces the lender's exposure to the risk of default, secured personal loans have lower interest rates than their unsecured counterparts. Besides physical property like houses or vehicles, monetary assets like investments, savings or future paychecks can also be used as collateral for a personal loan.

Small Business Loans

Small business loans are a popular way to support a growing business, and can be used to finance hiring, office space, or equipment. Collateral for these loans can include real estate, future payments by customers, and inventory. Owners of small businesses can also use their personal assets to gain approval for a loan, especially when running a business out of their home. In some cases, lenders require a "personal guarantee" from small business owners —a written promise that the borrower's personal assets can be seized if the company defaults on their debts.

Mortgages and Auto Loans

Mortgages and auto loans are the most common types of secured loans used by consumers. As mentioned previously, the asset being purchased (i.e. the house or car) is used as collateral for these loans. Most lenders mandate that assets be appraised to determine the proper value of the collateral. This process is particularly important for mortgage applicants, as lenders only approve home loans if the appraisal value of the home matches or exceeds the sale price.

Sources

U.S. Small Business Administration, What is Collateral?

Comments and Questions