What is collateral?

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In a Nutshell

Lenders want to know that you’ll pay back the loan they offer you. In order to do this, they may require collateral, a type of asset that can be used to secure the loan — and which can potentially be taken from you if you don’t pay what you owe.
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When offering you a loan, lenders want to limit their risk as much as possible and ensure they get their money back. That’s where collateral comes in.

If you let your friend borrow some money, you’d want to know they’re good for it, right? You’d want to find a way to limit the risk and ensure you get your money back. The same thing goes with lenders. But they have a more sophisticated way of going about it — through collateral.

In this article, we’ll explain how collateral works, where you may encounter it, and how it could help you get the kind of loan you want.

A definition of collateral

Collateral is something — some sort of property or asset — that you may need to provide to a lender to get a loan. In many cases, collateral is required for certain types of loans, like mortgages and auto loans.

Essentially, the collateral serves as a security measure for the lender. If you fail to make payments, your lender typically can take possession of the collateral as payment for the loan.

This offers the lender more assurance and security — in fact, collateral is described as “securing” the loan. Loans without collateral are known as unsecured loans.

Collateral can be a win-win for lenders and borrowers. It gives lenders more confidence, and it may score borrowers a lower interest rate.

Which types of loans require collateral?

There are various types of loans that typically require collateral. Below is a list of the types of loans as well as the types of collateral that can be used to secure the loan.

  • Mortgages — The home or real estate you purchase is often used as collateral when you take out a mortgage.
  • Car loans — The vehicle you purchase is typically used as collateral when you take out a car loan.
  • Secured credit cards A cash deposit is used as collateral for secured credit cards. In other words, your cash that is used as a deposit to get a secured credit card can be kept if you miss multiple payments.
  • Secured personal loans — A valuable item that the lender agrees to use as collateral, such as your home or your savings account, can be used for secured personal loans. If you fail to make payments on the loan, the lender can typically claim that asset.

As you can see, for each different type of loan there is something of financial value that is used to secure the loan.

For example, property such as a house or car can serve as a form of collateral when you take out a mortgage or car loan. While these items are given to you under a repayment term, they can go back to the lender if you don’t hold up your end of the bargain.

How collateral can help you

Although it might seem scary to have something of yours that has financial value used as collateral for a loan, it can actually be a benefit if you make your monthly payments on time and in full.

When you offer collateral for a loan, in some cases lenders will give you a lower annual percentage rate, or APR, than they otherwise would (this might not be the case for a mortgage or an auto loan).

That’s because they view a secured loan as a less risky investment. If you don’t end up paying, they still have a way to recoup costs through the collateral. Getting a lower interest rate could also cut down on the total cost of the loan and save you money.

About the author: Melanie Lockert is a freelance writer and editor currently living in Portland, Oregon. She is passionate about education, financial literacy and empowering people to take control of their finances. Her work has been f… Read more.