How do collateral work?
Collateral is something that helps secure a loan or guarantees that you will repay as agreed. When you borrow money with collateral, you agree that the lending bank can take the pledged asset and sell it. This way, the bank can recover any money you did not repay. Collateral makes it possible to obtain large loans and increases your chances of approval if you are having difficulty getting a loan. When you provide collateral, the lending bank takes on less risk, which means you are more likely to get a good rate on the loan. Learn more about how the process works.
Types of collateral
Any asset accepted by the lending bank as collateral, and compliant with laws, can be used as collateral. Generally, banks prefer assets that are easy to appraise and convert into cash. For example, cash in a savings account is ideal as collateral, because banks know how much it is worth, and it is easy to collect. Some common forms of collateral include:
- Cars
- Real estate (including equity in your home)
- Cash accounts
- Machinery and equipment
- Investments
- Insurance policies
- Valuables and antiques
- Future payments from customers, also known as “receivables”
Even if you are getting a loan for your business, you may pledge personal assets (like your family home) as part of a personal guarantee.
How much are assets worth?
Banks typically offer an amount less than the value of the pledged asset, and some assets may be significantly devalued. For example, a bank might only recognize 50% of your investment portfolio as collateral for a loan. This way, they improve their chances of recovering all their money if the value of the investments declines.
When applying for a loan, banks often quote an acceptable loan-to-value (LTV) ratio. For example, if you borrow against your home, banks may allow an LTV ratio of up to 80%. In this case, if your home is valued at $100,000, you could borrow up to $80,000.
If your collateralized assets lose value for any reason, you might need to pledge additional assets to keep the collateral loan in place. Similarly, you are responsible for the full amount of your loan, even if the bank takes your assets and sells them for less than the amount owed. If you default, the bank can file a lawsuit against you to collect any deficiency (the amount that remains unpaid).
Types of loans
There are many types of loans that allow you to borrow against collateral, including personal loans and business loans. Because many new businesses do not have a long track record of profitability, they often have to pledge collateral, such as personal items owned by the business owners.
In some cases, you get a loan, purchase something, and pledge it as collateral at the same time. For example, in cases of premium-financed life insurance, the lending bank and the insurance company often work together to provide both the policy and the collateral loan simultaneously.
A financed home purchase is a similar thing: the home secures the loan, and the bank can proceed with eviction on the home if you do not repay. Even if you are borrowing for fix-and-flip projects, lenders want to use your investment property as collateral. When borrowing for mobile or manufactured homes, the quality of the loan available will depend on the age of the home, the foundation system, and other factors.
There is also a variety of secured loans for people with bad credit. These loans can often be costly and can make matters worse, so it’s best to avoid borrowing in extreme cases. For instance, title loans allow you to borrow using your car as collateral. But be cautious with these loans: if you don’t repay, the lender can take the car and sell it – often without notifying you beforehand.
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Can you borrow without collateral?
If you prefer not to secure loans, you will need to find a bank willing to approve a loan based on your income and credit scores. Some options include:
- Unsecured loans from banks and credit unions, such as personal loans and credit cards.
- Online loans (including peer-to-peer loans), which are often unsecured loans.
- Getting someone to apply for the loan with you, putting their credit at stake to help you obtain approval.
In some cases, such as when buying a home, it may not be possible to borrow without using something as collateral (unless you have significant equity in the home). In other cases, borrowing without collateral may leave you with fewer options and more expensive options.
Frequently Asked Questions (FAQs)
Can collateral be used as a down payment on a house?
The down payment is typically 20% of the total home loan that you are expected to take out. You can use your existing assets, like stocks, gold, and other properties, to secure a loan for the down payment if needed. You will need to assess your assets first to see how they value as collateral for the loan.
What can be used as collateral?
Banks typically prefer assets that are easy to evaluate and convert to cash. Some banks have specific rules regarding the assets they will accept. Cars, real estate, future paychecks, jewelry, artwork, boats, stocks, antiques, savings accounts, and certificates of deposit are generally acceptable forms of collateral.
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Sources:
The Balance only uses high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Legal Information Institute. “U.C.C. § 9-203. Attachment and Enforceability of Security Interest; Proceeds; Supporting Obligations; Formal Requisites.”
Internal Revenue Service. “Frequently Asked Questions on Retirement Plans Related to Loans,” Questions 1 and 3.
Small Business Administration. “Collateral and Credit.”
Consumer Financial Protection Bureau. “How does the foreclosure process work?”
Federal Trade Commission. “What is the true cost of a car title loan?”
Experian. “What can be used as collateral for a personal loan?”
Source: https://www.thebalancemoney.com/collateral-loans-315195
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