Collateral is property (like a home or a car) that a borrower gives a lender to receive a loan. If the borrower can’t repay the loan, the lender is legally allowed to take the collateral to recover their money.
What Is Collateral?
Say you need to take a loan out to make a large purchase. It often happens to buy a car, a home, and other necessary life transactions. When a borrower subscribes to a lending agreement, the borrower is responsible for making payments. Collateral is essentially an asset or assets that a lender will accept as security for a loan.
Collateral can serve as protection for the lender. If a lender asks for collateral, the borrower must provide a piece of property that matches the value of the requested loan. This piece of property can be anything from land to a piece of expensive jewelry—as long as both the lender and borrower see value in the asset, it can be used as collateral. For example, the collateral used to secure title loans is the free-and-clear vehicle title of the borrower’s car.
Suppose the borrower fails to pay the principal and interest under the terms of the initial lending agreement. In that case, the lender may take the asset to recover their loss.
Why Would You Need Collateral?
Collateral is a way to mitigate or reduce the risk of loss on the lender’s side and increase available financial opportunities on the borrower’s side. A great thing about this is that the borrower has a high chance of benefiting from this financial relationship because collateral allows for much lower interest rates with greater values for the loan requested.
How Does Collateral Work?
In the example of attempting to obtain a loan for a car you plan to purchase, you may present the car as collateral to your lender. This means the lender will have possession of your car if you do not proceed to fulfill the loan repayment within the agreed-upon time frame. In this particular scenario, should your lender proceed to seize the asset, or your car, once it’s been made clear that the loan cannot be repaid, the lender can choose to sell the car to gain back the funds lost in the lending transaction.
Another example of a scenario that collateral could be involved in is a mortgage for a house. Should the homeowner stop making regular and sufficient payments on the mortgage, the loan provider has the power to move forward legally to seize the house.
What Kinds of Assets Can Qualify as Collateral?
Collateral is often pre-established by specific loan types (for example, mortgages or car loans, etc.). There are plenty of asset types that can be used as security for a loan. A few of those include physical property (residences or commercial spaces, plots of land, etc.) and vehicles.
Borrowers can also opt to offer the lender a list of valuable assets. This means the individual assets may not equate to the value needed for the loan, but as a collective group, they may cover the necessary costs. This particular kind of asset may increase the risk for the borrower but might still lead to lower interest rates.
Things To Consider When Looking at Using Collateral
Where collateral may seem like the way to go when deciding how to pay for a significant transaction, you may want first to consider what is at stake.
You should consider:
1) Your ability/capacity to pay in a limited amount of time.
2) Your willingness to utilize the assets that can function as collateral.
These items to consider can involve you taking a deeper dive into your day-to-day finances. You can look at things like your weekly/bi-weekly pay or salary. You can look at what costs you come upon every month (rent, utilities, bills, etc.). It may also be helpful to look at your everyday spending—from your morning coffee to the gas it takes to get to work. All of these items can be instrumental in deciding on both your capacity and willingness to move forward with collateral.
Another item to consider is your credit. Before even considering your options for collateral, your lender is likely to assess your credit responsibility. They will look at things like how often you use your credit cards and your outstanding balances. A better, more reliable credit history, in addition to a continuously high credit score, means the bigger the likelihood is that you appear trustworthy to a lender.