Collateral Definition, Types, & Examples (2024)

What Is Collateral?

Collateral in the financial world is a valuable asset that a borrower pledges as security for a loan.

For example, when a homebuyer obtains a mortgage, the home serves as the collateral for the loan. For a car loan, the vehicle is the collateral. A business that obtains financing from a bank may pledge valuable equipment or real estate owned by the business as collateral for the loan. In the event of a default, the lender can seize the collateral and sell it to recoup the loss.

Other nonspecific personal loans can be collateralized by other assets. For instance, a secured credit card may be secured by a cash deposit for the same amount of the credit limit—$500 for a $500 credit limit.

Key Takeaways

  • Collateral is an item of value pledged to secure a loan.
  • Collateral reduces the risk for lenders.
  • If a borrower defaults on the loan, the lender can seize the collateral and sell it to recoup its losses.
  • Mortgages and car loans are two types of collateralized loans.
  • Other personal assets, such as a savings or investment account, can be used to secure a collateralized personal loan.

How Collateral Works

Before a lender issues you a loan, it wants to know that you have the ability to repay it. That's why many of them require some form of security. This security is called collateral, which minimizes the risk for lenders by ensuring that the borrower keeps up with their financial obligation. The borrower has a compelling reason to repay the loan on time because if they default, they stand to lose their home or other assets pledged as collateral.

Loans secured by collateral are typically available at substantially lower interest rates than unsecured loans. A lender's claim to a borrower's collateral is called a lien—a legal right or claim against an asset to satisfy a debt.

In the event that the borrower does default, the lender can seize the collateral and sell it, applying the money it gets to the unpaid portion of the loan. The lender can choose to pursue legal action against the borrower to recoup any remaining balance.

Types of Collateral

The nature of the collateral is often predetermined by the loan type. When you take out a mortgage, your home becomes the collateral. If you take out a car loan, then the car is the collateral for the loan. The types of collateral that lenders commonly accept include cars—only if they are paid off in full—bank savings deposits, and investment accounts. Retirement accounts are not usually accepted as collateral.

You also may use future paychecks as collateral for very short-term loans, and not just from payday lenders. Traditional banks offer such loans, usually for terms no longer than a couple of weeks. These short-term loans are an option in a genuine emergency, but even then, you should read the fine print carefully and compare rates.

Collateralized Personal Loans

Another type of borrowing is the collateralized personal loan, in which the borrower offers an item of value as security for a loan. The value of the collateral must meet or exceed the amount being loaned. Lenders will typically lend only a percentage of the collateral's value, not 100% of its value. If you are considering a collateralized personal loan, your best choice for a lender is probably a financial institution that you already do business with, especially if your collateral is your savings account. If you already have a relationship with the bank, that bank would be more inclined to approve the loan, and you are more apt to get a decent rate for it.

Use a financial institution with which you already have a relationship if you're considering a collateralized personal loan.

Examples of Collateral Loans

Residential Mortgages

A mortgage is a loan in which the house is the collateral. If the homeowner stops paying the mortgage for at least 120 days, the loan servicer can begin legal proceedings, which can lead to the lender eventually taking possession of the house through foreclosure. Once the property is transferred to the lender, it can be sold to repay the remaining principal on the loan.

Home Equity Loans

A home may also function as collateral on a second mortgage or home equity line of credit (HELOC). In this case, the amount of the loan will not exceed the available equity. For example, if a home is valued at $200,000, and $125,000 remains on the primary mortgage, a second mortgage or HELOC will be available only for as much as $75,000.

Margin Trading

Collateralized loans are also a factor in margin trading. An investor borrows money from a broker to buy shares, using the balance in the investor's brokerage account as collateral. The loan increases the number of shares the investor can buy, thus multiplying the potential gains if the shares increase in value. But the risks are also multiplied. If the shares decrease in value, the broker demands payment of the difference. In that case, the account serves as collateral if the borrower fails to cover the loss.

Is Collateral Property?

Collateral guarantees a loan, so it needs to be an item of value. For example, it can be a piece of property, such as a car or a home, or even cash that the lender can seize if the borrower does not pay.

What Loans Do not Use an Asset as Collateral?

If you don't have any collateral necessary to secure a certain type of loan, you may want to consider looking into unsecured loans, such as a personal loan or credit card (both of which don't use an asset as collateral), as an alternative.

Do I Get Back My Collateral?

If you have any assets being used as collateral on a loan and don't miss any payments, you won't lose your collateral. However, if you fail to make payments on time and ultimately default on your loan, the collateral can then be seized and sold, with the profits being used to pay off the remainder of the loan.

The Bottom Line

You risk losing your collateral if you fail to pay back your debt. So to ensure you keep your car, home, or any other valuable asset being used as collateral on a loan, always make your payments on time to minimize any possibility of defaulting on your debt.

Collateral Definition, Types, & Examples (2024)

FAQs

Collateral Definition, Types, & Examples? ›

Collateral is when an asset is pledged to secure repayment. The five main types of collateral are consumer goods, equipment, farm products, inventory, and property on paper. All can be used as collateral when applying for loans, provided there is a recognizable value associated with the item.

What is a collateral example? ›

What Is Collateral? Collateral in the financial world is a valuable asset that a borrower pledges as security for a loan. For example, when a homebuyer obtains a mortgage, the home serves as the collateral for the loan. For a car loan, the vehicle is the collateral.

What is the definition and meaning of collateral? ›

collateral noun [U] (SECURITY FOR DEBT )

valuable property owned by someone who wants to borrow money, that they agree will become the property of the company or person who lends the money if the debt is not paid back: use something as collateral She used her house as collateral for a loan.

What is the best type of collateral? ›

Real Estate

Using real estate as collateral is common with a personal loan or mortgage. Financial institutions find real estate to be an attractive kind of collateral because retaining property values over time is typically manageable with real estate. Additionally, most real estate is worth at least $100,000 or more.

What is the most common form of collateral? ›

The three most common types of collateral for business loans are accounts receivable, inventory and other tangible assets such as real estate, machinery and equipment. Lenders may look differently at the same type of assets in different industries. Equipment is a prime example of this.

What are 2 examples of collateral for a loan? ›

Examples of what can be used as collateral for a personal loan include the following:
  • Your Vehicle.
  • Your Home.
  • Your Savings.
  • Your Investment Accounts.
  • Your Future Paychecks.
  • Art.
  • Jewelry.

What are two basic examples of what can be used as collateral by lenders? ›

Types of Collateral You Can Use
  • Cash in a savings account.
  • Cash in a certificate of deposit (CD) account.
  • Car.
  • Boat.
  • Home.
  • Stocks.
  • Bonds.
  • Insurance policy.
Mar 7, 2021

What are two synonyms for collateral? ›

  • bond.
  • collateral.
  • guarantee.
  • pawn.
  • pledge.
  • recognizance.
  • security.
  • surety.

What are collateral materials? ›

Marketing collateral is any media material used to promote a company's products or services. This includes everything from print materials like posters and flyers to digital content like catalogs and digital magazines. Marketing collateral is anything you can use to communicate your company's brand message.

What is a cash collateral? ›

What Is Cash Collateral? Cash collateral is cash and equivalents collected and held for the benefit of creditors during Chapter 11 bankruptcy proceedings. Cash and cash equivalents include negotiable instruments, documents of title, securities, and deposit accounts.

Is collateral good or bad? ›

Collateral loans come with some risk, since you could lose the asset you use to secure the loan if you fail to make payments. However, if you're on solid financial footing, a collateral loan can be well worth it.

What are the three C's of collateral? ›

Students classify those characteristics based on the three C's of credit (capacity, character, and collateral), assess the riskiness of lending to that individual based on these characteristics, and then decide whether or not to approve or deny the loan request.

What is acceptable collateral? ›

Types of collateral

Real estate, including your home, equity in your home or investment properties. Vehicles, including motor homes. Cash accounts (however, retirement accounts are usually an exception and won't count for collateral) Machinery and equipment from your business or personal use. Investments, stocks and ...

Why do people use collateral? ›

Collateral secures a loan, minimizing the risk for the lender — but not for the borrower. Collateral is a valuable asset (like a car, house or even cash) you can pledge to secure a loan. If you fail to repay your loan, the lender can seize whatever you've put up as collateral.

How many types of collaterals are there? ›

You can offer two types of collateral: Immovable property: Flats, houses, non-agricultural lands (you must mention the boundary and layout specification) Liquid security: Fixed deposits, bonds, LIC policies.

What cannot be used as collateral? ›

Explanation: The item that CANNOT be used as collateral for a loan is a bank account. Collateral is an asset or property that a borrower offers to a lender as a guarantee for a loan.

Can I use my house as collateral for a personal loan? ›

Any asset can potentially be used as collateral for a personal loan, including real estate, vehicles, savings accounts, investments, and valuables. However, it's important to have enough equity in your assets to justify using them as collateral.

What is proof of collateral? ›

To prove your ownership of the collateral you're offering, you'll have to provide additional documents like W-2s, bank statements, pay stubs, receipts, and deeds.

Can anything be used as collateral? ›

As far as common forms of collateral go, cash in a bank account, such as a savings account or certificate of deposit, usually works well since the value is clear and the funds are readily available. Garvey says you can use a car, house, jewelry or other valuable asset as long as you're the owner.

Can I use my home as collateral for a loan? ›

What does it mean to use my home as collateral? You use your home as collateral when you borrow money and “secure” the financing with the value of your home. This means if you don't repay the financing, the lender can take your home as payment for your debt.

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