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Collateral is a thing of value that a borrower can pledge to a lender to get a loan or line of credit; common examples of collateral include real estate, vehicles, cash and investments. Not only does collateral minimize the risk lenders are exposed to because it secures the financing, but it also can help borrowers access lower interest rates and higher loan amounts.
If you’re shopping for a loan, credit card or another source of financing, consider whether pledging collateral is a feasible option. We’ll walk you through how collateral works, as well as common forms of collateral and the types of loans that require it.
How Collateral Works
Collateral serves as evidence that a borrower intends to repay their debt. Requiring collateral for certain loans lets lenders minimize their risk by improving their ability to recoup outstanding debt in case the borrower defaults. Taking out a collateral loan, also known as a secured loan, typically involves a borrower giving the lender title to a specific piece of collateral. The collateral is often related to the use of the loan funds—as with a home mortgage or auto loan—but may also be more general, like cash, investments or other valuable assets.
As a result of this arrangement, the lender has a claim to the collateral—called a lien—meaning that if the borrower defaults, the lender can seize the collateral and sell it to recoup the outstanding debt. For this reason, the value of the collateral must be sufficient to cover the debt if the borrower defaults. In cases where the value of the collateral is insufficient, the lender can initiate legal proceedings in an attempt to collect the balance.
Types of Collateral
The type of collateral required is typically related to the type of loan it’s securing. However, collateral also can be other valuable assets. Here are the most common types of collateral:
- Real estate. Mortgages are collateralized by the financed home. Likewise, home equity loans and home equity lines of credit (HELOCs) are secured by the borrower’s equity in their home. Borrowers who own real estate can also use their property to secure other personal and business loans.
- Cars or other vehicles. If you take out an auto loan to purchase a vehicle, the car will serve as the collateral for that loan. That said, auto owners can also take out an auto equity loan, wherein the equity a borrower has in their vehicle serves as collateral for a personal loan. In both of these cases, the lender typically holds title to the vehicle until the loan is paid off.
- Valuable items. In addition to vehicles, other valuable personal property like jewelry, art and collectibles (like coins) may be used as loan collateral. In the case of a business loan, inventory may also serve as collateral. Importantly, using this type of collateral often requires an appraisal or other evaluation to determine the collateral’s value.
- Cash. Using cash as collateral involves taking out a loan with a bank where you also hold a savings account, money market account or certificate of deposit (CD). Here, the credit limit or loan amount is typically limited to the value of the account(s).
- Investments. In some cases, borrowers may use investment accounts as collateral—a process also known as securities-based lending or stock-based lending. Keep in mind, though, that if the value of your investments drops below the amount of your outstanding debt, the lender may require additional cash collateral.
What Types of Loans Require Collateral
A collateral loan is one that is secured by personal property, cash, investments or real estate that has value sufficient to cover the outstanding debt. Not all loans are secured, but there are some loans that typically require the borrower to pledge collateral. Collateral will likely be required if you’re considering one of these financing options:
Mortgages
Mortgages are one of the most well-known types of secured loans. When financing a home or other real estate, the buyer pledges that real estate as collateral so that the bank’s risk is limited in the case of default and subsequent foreclosure. While the owner holds the deed to the real estate, their title is encumbered by a mortgage that gives the lender the ability to foreclose on—and seize—the property if the borrower fails to make payments.
Auto Loans
As with mortgages, most auto loans are collateralized by the vehicle being financed. In the case of a car loan, however, the lender holds title to the vehicle until the loan is paid in full. If a borrower defaults on the loan, the bank can repossess the car.
Secured Personal Loans
In contrast to unsecured personal loans, secured personal loans require the borrower to pledge collateral to limit the lender’s risk. Though not all lenders offer this option, secured personal loans can make it easier for low-credit applicants to get approved. These secured loans can also help borrowers access lower interest rates or, perhaps, qualify for higher loan amounts.
Secured Credit Cards
If you have a low credit score—or haven’t developed credit history at all—it may be difficult to qualify for a credit card. This can make it even more difficult to build a credit history. To address this issue, some banks and credit card companies offer secured credit cards. With this type of card, the bank extends credit equal to (or close to) the cash a cardholder places in an in-house account and pledges as collateral.
Pros of Collateral Loans
Collateral has a number of benefits that make it a helpful tool when applying for loans, credit cards and lines of credit. These advantages may make a secured loan a good financing option:
- Collateral can help borrowers access credit or loans in spite of having a low credit score or limited credit history.
- Likewise, collateral loans can help borrowers build their credit by demonstrating on-time payments.
- Secured loans and credit cards may come with lower interest rates than their unsecured counterparts.
- Borrowers that provide collateral may be able to access larger loan amounts or higher credit limits than available with unsecured financing.
Cons of Collateral Loans
Still, the mechanics of collateralized loans mean that a secured loan may not be your best option. Here are some things to consider before pledging collateral:
- Using something as collateral puts the property at risk if the borrower defaults on the debt.
- Secured loans involve a more extensive application process that may include an appraisal.
- Oftentimes, the loan must be used to purchase the item serving as collateral.
Can You Get a Loan Without Collateral?
Collateral is a necessary element of many financing options—like mortgages, home equity loans and auto loans—but it is possible to get a loan without collateral. Unsecured personal loans, for example, provide borrowers an opportunity to access cash without having to pledge something like cash or investments as collateral. Likewise, most credit cards are unsecured, meaning that you can access a revolving line of credit without providing collateral.
Forbes Advisor Loans Writer Kiah Treece contributed to this article.
