What is collateral?

Collateral is an item of value that serves as security for a loan, which means the lender can seize the asset to sell if the borrower doesn't repay the debt. This gives the lender additional financial protection and reduces its risk, so secured loans may be available to borrowers who don't qualify for unsecured loans.

Key insights

• Taking out a secured loan requires you to put up collateral.
• Lenders have their requirements for what can be pledged as collateral.
• Unsecured loans do not require collateral but generally charge more interest and may require you to have a higher credit score.

Secured vs. unsecured loans

Secured loans are backed by collateral (an asset that can be sold if the borrower does not repay the loan), while unsecured loans have no collateral requirements. Some lenders offer both secured and unsecured loans. You can get secured personal loans and credit cards, but most often these types of borrowing are unsecured. Other loan types, like auto loans and mortgages, are generally considered secured debt.

Because unsecured loans don’t provide the protection of collateral, they often come with higher interest rates for the borrower.

Loan collateral explained

Personal loans provide upfront funding for borrowers to use for a number of purposes — like home improvement projects, for instance, or to consolidate credit card debt. As a borrower makes on-time payments of principal and interest, the lender recoups the initial loan amount and earns a profit from collecting interest. It can then use those funds to offer loans to other borrowers.

The downside for lenders: There’s always the risk a borrower won’t repay their debt, which means a loss for the lending institution. Collateral helps lessen this risk by giving lenders an alternative to collecting the funds they’re owed.

If a borrower defaults on a loan (i.e., misses payments or stops making payments altogether), the lender can take possession of the collateral and sell it to regain the loss.

Jeanne Kucey, CEO of JetStream Federal Credit Union, gave us a glimpse into the lender’s perspective on collateral.

“Lenders like collateral-backed loans because it’s less risky to them,” she said. “The borrower, however, risks seizure of their collateral if they miss their monthly payments. For instance, a vehicle that is used for collateral will generally be repossessed after three or more missed loan payments. The borrower can usually redeem the repossessed vehicle, but there will be additional fees, a big hit to their credit score and a loss of transportation.”

Collateral can be a home, a vehicle, a bank account or another item of significant value.

Types of collateral

Many different types of assets can be used as collateral for a loan, including the following:

• Property: When you close on a mortgage, you’ll sign a deed of trust or a mortgage (depending on your state’s laws) that names the property as collateral for the loan. This lets the lender create a lien on the property, which gives it an ownership claim until the loan is paid in full. If you default, the lender could foreclose and sell the property.
• Vehicle: With an auto loan, the vehicle you're purchasing is the collateral. If you fail to make your car payments, the lender has a legal right to repossess the vehicle and sell it. Cars can also be used as collateral for personal loans and other financing types, though this depends on lenders’ minimum equity requirements — depending on the vehicle's current value and how much you owe, you may not be able to use it as collateral.
• Bank account: Savings, checking, money market and other bank accounts (with the exception of retirement accounts like 401(k)s and IRAs) can be pledged as collateral. Your lender may require a minimum balance to qualify, though.

Other forms of potential collateral include precious metals, art, jewelry and valuable collectibles. The actual market value of these items is sometimes more difficult to determine than with other forms of collateral (like cash accounts), however, so these may be trickier to put up as loan security.

Is it a good idea to provide collateral?

As a general rule, you’re likely to get a lower interest rate with a secured personal loan than with an unsecured one. Keep in mind that even a slight reduction in the interest rate could save you a significant amount of money over the life of the loan.

“If you’re confident that you can make your payments on time and want a lower rate, collateral will be your best option,” Kersey said. “If you don’t have collateral available, you might still be able to get an unsecured loan at a reasonable interest rate if you have a high credit score and a low debt-to-income ratio.”

Bottom line

Collateral is an item of value that’s pledged as security for a loan. Secured loans, like mortgages and auto loans, require collateral. Most personal loans don’t have this requirement, which is why they often have higher interest rates.

Lenders ask for collateral because it lessens their risk of financial loss, but borrowers need to be aware of the risks associated with pledging collateral: If you fail to make payments, the lender can take possession of the item and sell it. Make sure you weigh the benefits and downsides of both secured and unsecured loan options before deciding on the right loan for you.