What is Collateral and How Does It Work?
There are many different things to consider when taking out a loan. You'll want to look at the APR (annual percentage rate), the size of the loan, and the repayment term. Something that underpins the entire loan process is collateral, but what does collateral mean?
What is Collateral?
Here's how we define collateral: it is an asset offered to a lender as security for a loan. If the borrower defaults on their loan repayments, the lender has the right to seize the asset as an alternative form of payment. The lender can then sell the collateral to cover their losses from the initial loan.
Collateral for a Loan Examples
There are several different examples of collateral, which largely depend on the nature of the loan. Let's run through some of the most common types of loans and what is collateral in these situations.
When you take out a mortgage, the lender uses your property as the collateral. If the owner of the property is unable to fulfill their mortgage payments, the lender is able to take control of the house and sell it to recoup their losses on the mortgage. This is known as foreclosure.
Knowing what is collateral for this type of loan is similarly straightforward. If you've used a loan to help you purchase a vehicle, then that vehicle will be the collateral. If you default on your car loan, then the lender is able to take possession of the vehicle and sell it.
It is possible to take out a personal loan that doesn't require any examples of collateral. However, many personal loans come in the form of 'secured personal loans' or 'collateralized personal loans'. In these scenarios, the individual offers valuable assets as collateral for their loan.
The collateral for a loan example can take several different forms, which depends on the size of the personal loan. The key factor is that the collateral must have a value greater than the size of the loan. Just as with mortgages and auto loans, the lender can take ownership of the collateral if the borrower defaults on payments.
These are a few possible examples of collateral that could be required to secure a personal loan:
- Savings accounts
- Future salary
- Real estate
What is Collateral's Usefulness for a Borrower?
On the surface, it might appear that collateral only works to give further power to the lender. However, collateral can improve the quality of the loan for the borrower.
By offering up collateral to the lender, the borrower is showing a strong commitment to paying back their loan. Because the collateral reduces the risk of default, the lender is willing to give more back to the borrower:
- A loan secured with collateral will often have a lower APR (annual percentage rate), which can save the borrower money in the long term.
- A borrower with a poor credit score may only be able to secure a loan by offering collateral.
- You may be able to secure a collateral credit card by offering up an asset (usually cash).
- By taking out a loan with your current financial institution, you may be able to secure a better rate. Banks enjoying building relationships, and your savings account can be used as collateral with no extra effort on your part.
Now that you know what is collateral, should you be afraid of it? Terms like 'foreclosure' and 'repossession' are undoubtedly scary terms, but they only become issues when payments default.
If you know that you will make regular repayments on your loan, then offering collateral may be able to secure you a better interest rate. This could save you money over the course of the loan repayment.