Collateral

Collateral summary:

• Collateral can be anything of value used to secure a loan.

• If you don’t make payments on a loan as agreed, a lender can sell your collateral. 

• For a mortgage, your home is collateral; for an auto loan, your car is.

Collateral definition and meaning

When collateral is involved in a loan, the borrower is thought to have “skin in the game.” In other words, borrowers have something to lose if they fail to make payments as agreed. 

If you don’t repay the loan, the lender can sell your collateral to recover the money you owe. Cars and homes are common examples. When you get a car loan, the car is the collateral. When you get a mortgage, the home is the collateral.

Key concept:

Collateral helps protect the lender.

More about collateral 

Collateral can be anything of value used to guarantee a loan. Generally, it must be valuable enough to cover the lender’s losses by reselling the items if payments aren't made. The value of the collateral is typically equal to or greater than the loan.

To protect their interests, lenders generally require collateral to have a value relative to the loan amount. Let’s say someone needs to borrow $10,000 and offers a rare coin worth $5,000 as collateral. While the lender might provide a $5,000 loan in return for the coin, it’s highly unlikely to lend the entire $10,000.

Often, the item you’re borrowing for is also the collateral. For example, your home is the collateral for your mortgage. Cars, boats, and recreational vehicles are other good examples of loan collateral. 

Collateral: a comprehensive breakdown

Loans come in two types: unsecured and secured. An unsecured loan doesn’t ask for collateral. The most common types of collateral-free credit accounts are unsecured personal loans (most personal loans) and traditional credit cards. If you stop making payments, the lender has nothing to repossess. The lender would need to take other steps to recover their losses, such as suing you for the debt.

The other type of loan is secured, meaning collateral (something of value) guarantees the loan. 

You might be able to hold onto your collateral while you’re paying off the loan, but the lender has the right to repossess it if you default on the debt. In some cases (such as with pawn shop loans), access to your collateral might be restricted. You get your collateral back when you pay off the loan. 

Secured loans include:

• Mortgage loans, including home equity lines of credit (HELOCs)

• Vehicle loans

• Pawn shop loans

• Car title loans

• Life insurance loans

• Secured credit cards

Collateral benefits both the lender and the borrower. For the lender, collateral lowers the financial risk. For this reason, borrowers with lower credit standings could have an easier time qualifying for the secured loan. 

For the borrower, secured loans typically come at a lower cost compared to unsecured loans, because of that financial safety net for the lender. It would be very normal to have a credit card with a 25% APR and a mortgage with a 7% APR. That difference can largely be chalked up to collateral.