Collateral

Collateral
Collateral is something of value that a borrower pledges in order to get a loan. If the borrower fails to repay the loan, the lender is allowed to seize the collateral and sell it to recover the money that’s owed.

What is Collateral?

Collateral is another term for an asset or property that a borrower provides a lender in order to receive a loan. If the borrower stops making agreed upon payments, the lender is entitled to take the collateral in order to recover their losses.(1)

How does Collateral work?

With collateral, a borrower pledges something of value to receive a loan. Physical property like real estate, a vehicle, and equipment are commonly used as collateral. Financial assets – such as stocks and bonds, or a savings account – are also common forms of collateral. Collateral can be almost anything of value, but lenders prefer collateral that can easily be sold, like physical property, or financial accounts that guarantee cash.

During the length of the loan, the borrower retains ownership of the collateral. If the borrower defaults, the lender is legally entitled to seize the collateral. The lender can then sell it and use the money to cover the outstanding balance on the loan.

Why is Collateral used?

Loans that involve collateral are called “secured loans,” as the collateral protects the lender from losses. Because of this, lenders are more likely to approve a loan if the borrower pledges collateral. Borrowers whose previous loan applications were denied can use collateral to increase the chances that they’ll be approved. Collateral is usually required for large loans, as the lender risks losing a lot of money if the borrower defaults.

How much Collateral is needed for a loan?

For a loan to be considered fully secure, the value of the collateral must equal or exceed the amount of the loan.[1] The exact value that a lender will deem acceptable varies, and it largely depends on the type of collateral that’s offered – whether the collateral is real estate, equipment, or financial assets, for instance. However, a lender will usually offer a loan for no more than 75 percent of what the collateral is worth.[2]

How is Collateral calculated?

The value of collateral is determined by an expert through an official appraisal process. Lenders, however, typically do not recognize the full value of the collateral. Instead, for the purposes of the loan, lenders will only recognize the collateral’s fire-sale value, as that’s how much they’re likely to receive if the borrower defaults and the collateral is sold to cover the outstanding balance.[3]

What kind of Collateral is needed for a loan?

Collateral can be almost anything of value, and this is especially true for personal loans and small business loans. However, some types of loans almost always entail certain types of collateral. For example, with a mortgage loan, the home that a borrower is purchasing is usually collateral. And for a title loan, the borrower’s vehicle is almost always the collateral.

Are Collateral loans a good idea?

The big risk of a loan involving collateral is obvious – borrowers can lose their property. This can cause disastrous consequences if the collateral is, for instance, the borrower’s home or vehicle. However, secured loans offer advantages as well. By pledging collateral, borrowers can qualify for a lower interest rate and a higher borrowing limit. If the borrower has previously been denied for a loan, sufficient collateral will make lenders far more likely to approve the loan request.

References:

  1. “Collateral.” Investopedia. Accessed February 16, 2016 at http://www.investopedia.com/terms/c/collateral.asp.

  2. “Collateral.” KeyBank. Accessed February 16, 2016 at https://www.key.com/html/collateral-bank-lending-process.html.

  3. “Collateral Value.” Investopedia. Accessed February 16, 2016 at http://www.investopedia.com/terms/collateral-value.asp.