Collateral is something that helps provide a loan. When you borrow money, you agree (somewhere in the fine print) that your lender can take something and sell it to get their money back if you fail to repay the loan. Collateral makes it possible to get large loans, and it improves your chances of getting approved if you have a hard time getting a loan.
When you pledge collateral, the lender takes less risk, which means you are more likely to get a good price.
How Collateral Works
Collateral is often required when the lender wants some assurance that they are not losing all their money. If you have an asset as collateral, your lender has the right to take action (assuming you stop making payments on the loan): they hold the collateral, sell it and use the sales proceeds to pay off the loan.
Contrast a collateral loan with an unsecured loan, where already a lender can do the thing your credit or legal action against you.
Lenders would prefer, above all, to get their money back. They do not want to bring legal action against you, so they try to use collateral as a guarantee. She doesn’t even want to deal with your collateral (they are not in the business of owning, renting and selling houses), but that is often the simplest form of protection.
Types of Collateral
Any asset that your lender accepts as collateral (and that is permitted by law) can serve as collateral. In general, lenders prefer assets that are easy to value and convert into money. For example, money in a savings account is great for security: lenders know how much it is worth, and it is easy to collect. Some common forms of collateral include:
- Real estate (including the equity in your home)
- Cash accounts (retirement accounts usually do not qualify, but there are always exceptions)
- Machines and equipment
- Insurance policy
- Valuables and collectibles
- Future payments from customers (receivables)
Even if you are getting a business loan, you can pledge your personal assets (such as your home) as part of a personal guarantee.
The valuation of your Assets
In general, the lender will offer you less than the value of your given assets. Some assets would be heavily discounted. For example, a lender would only recognize 50% of your investment portfolio for a collateral loan. That way, they improve their chances of getting all their money back in case the investments lose value.
When applying for a loan, lenders often quote an acceptable loan to value ratio (LTV). For example, if you borrow against your home, lenders can increase an LTV up to 80%. If your home is worth $ 100,000, you can borrow up to $ 80,000.
If your pledged assets lose value for any reason, you may have to pledge additional assets to hold a collateral loan in place. You are also responsible for the full amount of your loan, even if the bank takes your assets and sells them for less than the amount you owe. The bank can take legal action against you to collect deficiencies (the amount that has not paid off).
Types of Loans
You can take collateral loans in a variety of places. They are often used for business loans and personal loans. Many new companies, because they do not have a long track record to work with a profit, are required to pledge collateral (including personal items that are part of business owners).
In some cases you get a loan, buy something, and promise as collateral all at the same time. For example, in premium funded life insurance cases, the lender and insurer often work together to provide the policy and collateral loan at the same time.
Buying a funded home is right: the home secures the loan and the lender can foreclose the home if you don’t repay it. Even if you borrow for fix-and-flip projects, lenders want to use your investment property as collateral. When borrowing for mobile or manufactured homes, the nature of the loan will depend on the age of the home, the foundation system, and other factors.
There are also some collateral loans for people with bad credit. These loans are often expensive and may only be used as a last resort. They go by a variety of names, such as car title loans, and generally involve using your car as collateral. Be careful with these loans: if you do not repay, your lender can take the vehicle and sell it – often without prior notice.
Borrow without collateral
If you prefer not to pledge collateral, you need to find a lender who is willing to hand over money based on your signature (or someone else’s signature). Some of the options are:
- Unsecured loans, such as personal loans and credit cards
- Online loans (including peer-to-peer loans) are often unsecured loans with good prices
- Getting a cosigner to apply for the loan with you – putting their credit at risk
In some cases, such as buying a home, borrowing without using something like collateral is probably not possible (unless you have a large equity in the home). In other situations, it may be an option to do without collateral, but you will have fewer choices and you will have to pay a higher rate to borrow.