What's That About Collateral, Anyway?
Collateral Meaning, Classifications, and Illustrations
Collateral is essentially your personal, valuable asset you promise a lender as security for a loan. Picture this: when you buy a house and secure a mortgage, the house itself acts as the collateral. In the case of a car loan, your prized vehicle serves as collateral. For businesses, they may offer valuable equipment or real estate to secure a loan. If things go south and you can't repay the loan, the lender can swoop in and snatch up the collateral to help recover their losses.
Secured personal loans can be backed by other assets aside from real estate or vehicles. For instance, a secured credit card might require a cash deposit equivalent to the credit limit ($500 for a $500 credit limit, to keep it simple).
Quick Facts
- Collateral lowers the risk for lenders, ensuring that borrowers refrain from defaulting since they could lose their property.
- Higher loan interest rates are typically associated with unsecured loans.
- Both mortgages and car loans are examples of collateralized loans.
- Personal assets, such as savings or investment accounts, can be used to secure a collateralized personal loan.
How Collateralworks in Action
Before a lender hands over a loan, they want to feel confident that you can repay it. Enter collateral, the security that helps minimize the risk for the lender by guaranteeing you'll meet your financial obligation. Since losing their collateral is a compelling reason to maintain timely payments, borrowers have a strong incentive to pay back their loans promptly.
Lenders' claims to a borrower's collateral are known as liens, a legal right or claim against an asset to settle a debt. If you default on your loan, the lender can seize the collateral, sell it, and apply the proceeds to the unpaid portion of the loan. They may also decide to pursue legal action if necessary to recover any remaining balance.
Types of Collateral and Loan Types
The nature of the collateral often depends on the type of loan. For example, when you take out a mortgage, your home automatically becomes the collateral, and the same goes for a car loan – the car. Commonly, lenders accept various types of collateral, including cars (on the condition they are fully paid off), bank savings deposits, investment accounts, and – with some exceptions – certain retirement accounts.
Future paychecks can also serve as collateral for very short-term loans, provided they come from payday lenders or traditional banks (usually for terms of a few weeks). Short-term loans can be a viable option in emergencies, but it's crucial to read the small print carefully and compare rates.
Collateralized Personal Loans
A collateralized personal loan occurs when a borrower offers an item of value as security for a loan. The value of the collateral should meet or exceed the amount being borrowed. Lenders generally won't provide 100% of the collateral's value, but they'll lend a percentage of it.
When considering a collateralized personal loan, your best bet is likely a financial institution you already do business with, particularly if your collateral is a savings account with that same institution. This existing relationship might increase your chances of approval and obtaining a favorable rate.
Important
Consider using your current financial institution if you're thinking about a collateralized personal loan, but shop around and compare rates with other lenders.
Collateral Loan Examples
Residential Mortgages
If a homeowner fails to make mortgage payments for 120 days, the loan servicer might initiate legal proceedings, eventually leading to the lender foreclosing on the house to recoup the remaining loan principal.
Home Equity Loans and Lines of Credit (HELOC)
A home can also serve as collateral for second mortgages or home equity loans/lines of credit (HELOC). The maximum amount borrowed in such cases will depend on the available equity. For example, if a home is valued at $200,000, and $125,000 remains on the primary mortgage, only a $75,000 second mortgage or HELOC will be available.
Margin Trading
Collateralized loans come into play in margin trading. An investor takes out a loan from a broker to purchase shares, using the balance in their brokerage account as collateral. The borrowed funds increase the number of shares the investor can buy, potentially multiplying gains if the shares appreciate in value. However, the risks are also magnified since losses can lead the broker to demand payment or seize the account as collateral if the borrower can't cover the loss.
Is Collateral Property?
While collateral relates to a property, it isn't considered property itself. It assures a loan and needs to hold value, making it suitable for lenders to seize if necessary (e.g., a car, home, or cash).
Loans without Collateral
If you don't have an asset to put up as collateral or prefer unsecured loans, you can explore alternatives like personal loans or credit cards. These loans don't need an asset as collateral.
Will I Get My Collateral Back?
As long as you make your payments on time and avoid defaulting on your loan, you should keep your collateral. But if you fail to keep up with payments and ultimately default, the lender can seize and sell the collateral, using the proceeds to settle the outstanding loan balance.
The Last Word
Defaulting on a loan puts your collateral at risk, so it's crucial to prioritize timely payments to maintain possession of your car, home, or any other valuable asset serving as collateral for a loan.
- In the context of investing, an Initial Coin Offering (ICO) could potentially be used as a form of collateral for a margin trading loan, where the balance in the investor's brokerage account serves as collateral for the borrowed funds.
- While investing in personal-finance ventures through Defi (Decentralized Finance) ecosystems, the digital assets held in the investor's wallet could function as collateral for various loan types within the DeFi space.
- When trading in an online marketplace, the tokens you accumulate from various investments could act as collateral to secure short-term loans from peer-to-peer lenders or traditional financial institutions.
- For everyday business transactions, offering company assets like equipment, real estate, or even business accounts as collateral can help secure a line of credit or business loan, easing the financial burden during operational growth or unexpected expenses.
