What Is Collateral for a Personal Loan, Mortgage, or Other Debt Obligation?
Collateral is any asset or belonging that you use to backup a loan. If you’re not able to pay off your debt to a lender, the lender has the right to take the asset or belonging you put up as collateral.
Collateral is a way for lenders to lower the risk they’re taking on when they provide you with a loan. It’s common for lenders to require collateral and it can be provided in many forms, including:
- Future paychecks.
- Bank savings deposits.
- High-value items, such as jewelry or artwork.
When you review loan terms, it’s important to understand if collateral is involved in the loan and the circumstances that can allow the lender to take the collateral from you.
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Agreeing to a loan that includes collateral can feel unsettling since you’re putting your belongings or assets at risk. However, if you feel confident in your ability to make your monthly payments on time and to eventually pay the loan in full, collateral can actually be beneficial.
Collateral loans are called “secured loans” because they provide the lender with additional security. If you default on the loan, the lender isn’t left with nothing and takes the collateral. Your collateral can then be re-sold, so the lender can recoup some of the losses associated with the unpaid loan. This allows the lender to feel more secure taking on your loan. Since collateral allows the lender to assume less risk, you may be offered better loan terms, such as a lower interest rate.
Examples of Loans That Use Collateral
You won’t be required to put up collateral for every type of loan you apply for. However, there are specific loans that do have collateral requirements.
When you borrow money from a bank or financial institution for a personal expense, it’s considered a personal loan. You might need to take out a personal loan to pay for a vacation or an engagement ring. Some personal loans don’t require collateral while others do. To make your unsecured personal loan a secured personal loan, you’ll need to put down some collateral.
You can try to provide the lender with items of value, such as jewelry, diamonds, or other high-value possessions, to use as collateral. If the lender agrees, you may be provided with better loan terms or a lower interest rate than if you didn’t put up any collateral at all.
Small Business Loans
Small businesses take out small business loans with financial institutions to help pay for operating costs, new equipment, larger office space, or other expenses. To make the lender feel more secure about a loan, a borrower can use collateral, such as a future payments, equipment, or real estate, to secure the loan terms. When a small business offers collateral for a small business loan, the lender can take these items or payments if the borrower defaults on the loan.
You may need to obtain a mortgage when you buy a home or property but can’t pay the full purchase price as one lump sum. Mortgages are one of the most common secured loans because the home or property you’re purchasing is usually used as collateral for the loan. If you fail to make your mortgage payments on time, the financial institution takes over ownership of the home and can re-sell it to recoup losses from the unpaid mortgage.
When you purchase a car using an auto loan, you’re borrowing money from a financial institution to buy your vehicle. However, similar to mortgages, with an auto loan the car is used as collateral for the loan. Your car can be repossessed by the financial institution if you fail to adhere to the loan terms.
Predatory lenders are creditors with malicious intent that prey on borrowers by offering risky and abusive loan terms. These terms usually set borrowers up for failure and make it nearly impossible to pay off the loan. Often, predatory lenders will use their abusive practices to earn the rights to a borrower’s collateral so they can sell this collateral for profit.
If you identify unfair loan terms or predatory lender warning signs, such as offering a loan regardless of your credit score, be cautious before agreeing to the loan. The lender may sneak in unreasonable loan terms that make it impossible for you to keep the collateral you agreed to put up for the loan.
How to Avoid Collateral
As a borrower, collateral can be beneficial because a lender may feel more secure offering you a loan, which can lead to better loan terms and a lower interest rate. In some cases, borrowers may not qualify for loans if they don’t provide collateral as insurance against defaulting.
However, it may be possible to avoid providing collateral on some loans. If you have a strong financial history and/or a good credit score, the lender may feel confident enough to provide you with a loan that doesn’t include collateral as a stipulation. To avoid collateral, a lender may ask you for proof of income or bank account balance information to ensure you’re financially reliable before dispensing of the collateral requirement.
Collateral requirements depend on the nature of the loan and the lender. Collateral can increase the lender’s confidence in the loan, so they may offer better loan terms. Putting up collateral for a loan can feel intimidating, but it can be a deciding factor on whether you qualify for satisfactory loan terms.
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This post was updated December 12, 2019. It was originally published December 12, 2019.