A mortgage is a legal claim on any collateral you provide to obtain a loan. It allows the lender to seize the collateral if you stop making payments on your loan.
Definition and Example of a Mortgage
A mortgage is a legal claim by the lender on any collateral you provide to obtain a loan. If you agree to a mortgage and eventually fail to repay the loan, the lender has the right to seize your collateral.
It is common to grant a mortgage on loans that require collateral, such as mortgages and auto loans.
For example, if you take out a mortgage, your closing documents will give the lender a mortgage on the home you are purchasing. This mortgage gives the lender the right to reclaim the home if you default on your mortgage.
Note: Mortgages can be beneficial for both the lender and the borrower. It gives the lender more confidence that you will repay your loan, allowing them to charge lower interest rates.
How Does a Mortgage Work?
A mortgage allows the lender to seize the collateral if you default on your loan. However, the lender can only do this if the mortgage is valid.
The Uniform Commercial Code stipulates three criteria that a mortgage must meet to be considered legally valid:
- You have signed a mortgage agreement granting rights to the secured party (the lender).
- The value of the collateral has been determined by the secured party.
- You (the debtor) own the collateral.
The lender must also perfect the mortgage, which means ensuring that there are no other creditors on the collateral. The exact steps the lender takes to perfect the mortgage can vary depending on where you live.
Note: If you are preparing to close on a mortgage, you should familiarize yourself with some of the documents you will be signing. Knowing what to expect at closing will help you understand what to look for in your closing documents.
Secured Loans vs. Unsecured Loans
Secured Loans Unsecured Loans
Loan backed by collateral or property Loan not backed by any type of collateral
If you default on the loan, the lender can seize the collateral If you default on the loan, the lender can start the collections process
Since the loan is less risky for the lender, it usually carries lower interest rates Since these loans are riskier, they usually carry higher interest rates
Mortgages and auto loans are examples of secured loans Credit cards are an example of unsecured loans
A secured loan is a loan that is backed by some type of collateral. For example, if you take out an auto loan, the car you are purchasing is used as collateral.
So if you stop making payments on your auto loan, the lender can repossess the car and sell it to recover any lost money. The collateral requirements make secured loans less risky for your lender, so they often come with lower interest rates.
In contrast, an unsecured loan, like a credit card, does not have collateral requirements. If you default on your credit card, the lender can start the collections process, but there is no collateral to recover. This lack of collateral makes unsecured loans riskier for your lender and often results in higher interest rates.
The Takeaway
A mortgage is a legal claim of the lender on the collateral used to secure the loan. If you default on the terms of your loan, the lender can seize the collateral to recover some lost funds. Mortgages make the loan less risky for your lender, so you are likely to get lower interest rates. If you apply for a mortgage or auto loan, your closing documents will specify the mortgage for the lender on the collateral.
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Sources:
- Consumer Financial Protection Bureau. “What Is a Security Interest?” Accessed Dec. 21, 2021.
- Uniform Council Code. “Uniform Commercial Code Revised Article 9. Secured Transactions.” Page 56. Accessed Dec. 21, 2021.
- Consumer Financial Protection Bureau. “Differentiating Between Secured and Unsecured Loans.” Accessed Dec. 21, 2021.
Source: https://www.thebalancemoney.com/what-is-a-security-interest-5213937
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