Collateral is used when an individual borrows money from a lender to give the lender protection that if the borrower defaults on the loan repayments the lender can seize the collateral to recoup some or all of their losses.
For example, if a borrower wants a loan of $50,000 they may use their house as collateral to secure the loan. If the borrower failed to make the loan repayments, the lender could seize the house to sell it and recover their losses, therefore minimizing their risk.
How collateral works
Collateral works to secure a loan and give the lender security that the borrower can afford to repay the loan, but should they not make the repayments the lender has the collateral to sell to cover the principal costs of the loan.
There are many types of collateral that can be used but two of the most common types are mortgages which are collateralized by the real estate and the collateral for a car loan is the vehicle purchased with the loan.
Taking the first example of a mortgage, if the homeowner or borrow failed to keep up with their mortgage repayments, the mortgage lender can sell the real estate to settle the mortgage. Similarly, if a borrower defaults on their car loan repayments, the lender can seize the car to settle the outstanding loan amount.
Loans that require collateral are called secured loans and often have lower interest rates than unsecured loans. A lien is the name given to the lender’s claim to a borrower’s collateral, and gives the lender the legal right to claim against an asset to satisfy a debt.
Types of collateral
The different types of collateral that can be used as security for a loan include:
Real estate
Vehicles
Bank savings deposits
Investment accounts
Future paychecks
Examples of collateral loans include:
Residential mortgages
If the homeowner stops paying the mortgage for at least 120 days, the mortgage lender can begin financial proceedings to take possession of the home through foreclosure. The lender can then sell the home to settle the remaining principal mortgage balance.
Home equity loans
A home can also be used as collateral on a second mortgage or home equity line of credit. This can only occur if the equity in the collateral property is greater than the loan amount. For example, if the second mortgage required is $175,000 there must be at least $175,000 equity in the primary mortgage.
Margin trading
Collateralized loans are also used in margin trading. When an investor borrows money from a broker to buy shares, they use the balance in their investor’s brokerage account as collateral.
What else do you need to know?
Help borrowers get loans
Using collateral to secure a loan can help individuals borrow larger amounts of money. It can also give them favorable interest rates, as the interest rates of secured loans is usually significantly lower than unsecured loans.
Enables investors to buy more shares
In terms of margin trading, a form of collateralized loan, investors can borrow money from brokers to buy more shares and potentially earn bigger returns. The balance in the investor’s brokerage account is used as collateral to secure the loan.
Can be high risk
Using collateral to secure a loan is a standard method of lending, but when borrowers overstretch themselves, i.e. buying a house that is more than they can comfortably afford, it can bring higher risk. If they default on mortgage repayments they could stand to lose their house.
