What Is Collateral?
How Collateral Works
Different types of collateral
Illustrations for Collateral Loans

Personal Finance Credit

Collateral Definition, Types, & Examples
By Julia Kagan
Updated September 25 2022
Review by Amy Drury
Checked for accuracy by Ryan Eichler
Collateral

Investopedia / Zoe Hansen
What Is Collateral?

Collateral in the financial world is a valuable asset that a borrower pledges as security for the loan.

When a homeowner gets a mortgage, the home is used as collateral for the loan. When it comes to a car loan, the vehicle is the collateral. A business that obtains financing from a bank may make a pledge of valuable assets or real property owned by the business as collateral for the loan.

The loan that is secured by collateral has an interest rate that is lower than an unsecured loan. In the event of insolvency, the lending institution is able to seize the collateral and sell it in order to recover the losses.
The most important takeaways

Collateral is an asset of value that can be pledged in order to help secure the loan.
Collateral reduces the risk for lenders.
If a borrower defaults on the loan the lender may confiscate the collateral and trade it in to cover its losses.
The mortgage and the car loans are two types of collateralized loans.
Personal assets like such as a savings or investment account, are able to be used to secure the collateralized personal loan.

How Collateral Works

Before a lender gives you with a loan the lender wants to ensure that you have the ability to pay back the loan. That's why many of them require some type of security. The security is known as collateral, which reduces risk for lenders. It helps to ensure that the borrower stays on track with their financial obligations. In the event that the borrower defaults, the lender can confiscate the collateral and trade it in, transferring the proceeds to the unpaid portion that is due to the loan. The lender may decide to take legal actions against the borrower in order to recover any remaining balance.

As previously mentioned collateral can come in many forms. It normally relates with the type of loan, so the collateral for a mortgage is the home, and the collateral for the car loan is the car the loan is secured by. Other nonspecific, personal loans may be secured through other assets. For example the secured credit card may be secured by an cash deposit of the same amount of the credit limit, i.e. $500 for a $500 credit limit.

The collateral-backed loans are usually offered at significantly lower interest rates than unsecured loans. A lender's claim on a borrower's collateral is called a lien. It is a legally binding right, or claim on an asset to settle the debt. The borrower must have a compelling reason to repay the loan on time because if they default, they risk losing their home or any other asset secured as collateral.
Types of Collateral

The type of collateral is typically determined by the loan kind. If you get an mortgage, your home becomes the collateral. If you get the car loan and the car is the collateral for the loan. The types of collateral that are typically accepted by lenders include cars, but only in the event that they are paid in full, bank savings deposits and investment accounts. Retirement accounts aren't usually accepted as collateral.

You also may use future paychecks as collateral for short-term loans, and not just by payday lending companies. Traditional banks provide these loans typically for terms of no more than a few weeks. These short-term loans can be a viable option in the event of a real emergency, but even then, you should be sure to read the fine print and compare rates.
Collateralized Personal Loans

Another form that borrows money is the personal collateralized loan that is where the borrower pledges an item of value in exchange for security to secure the loan. The value of the collateral must be greater than or equal to the amount of money being borrowed. If you are considering a collateralized personal loan, your best choice to borrow from is likely an institution with which you have already established a relationship with, particularly if your collateral is your savings account. When you've already established a working relationship to the institution, the institution is more likely to accept the loan, and you are more likely to secure an acceptable rate.

Make sure to choose a financial institution with whom you have a previous relationship when you're looking at an uninvolved personal loan.
Illustrations for Collateral Loans
Residential Mortgages

A mortgage is an loan in which the house acts as the collateral. If the homeowner does not pay the mortgage for a minimum of 120 days after which the loan servicer may initiate legal proceedings which can cause the lender to eventually becoming the owner of the property by foreclosure.1 When the property is given to the loan lender, it can be sold to repay the remaining principal on the loan.
Home Equity Loans

A home can also serve as collateral on the second loan, such as a mortgage or home equity line (HELOC). In this scenario, it is important that the total amount for the loan will not exceed the available equity. For example, if a home is valued at $200,000, and $125,000 is left on the primary mortgage, a second mortgage or HELOC will be available only up to $75,000.
Margin Trading

Collateralized loans can also be a factor in margin trading. A buyer borrows money from a broker to purchase shares, using the balance of the investor's broker account for collateral. The loan increases the amount of shares an investor is able to purchase, multiplying the potential gains should the shares appreciate in value. But the risks are also multiplied. If the shares decrease by value, then the broker demands payment in the amount of difference. In that case the account acts as collateral in the event that the borrower is unable to pay for the cost.
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Related Terms
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A non-recourse debt is a type of loan that is secured by collateral, usually property, and where the lender assumes a greater risk of default if the borrower does not pay in the loan.
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Signature Loan
A signature loan is a type of personal loan offered by banks and other finance companies . It relies only on the signature of the borrower and commitment to pay collateral.
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Collateralization: Definition, how it works and Examples
Collateralization is the use of a valuable asset in order to protect a loan against default. The collateral is able to be taken by the lender in order to compensate any loss.
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An prior lien a lien in which the lien is recorded prior to any other claim.
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