What Is Collateral?

How lenders value collateral

If you use collateral to secure a loan and the loan isn’t paid according to the terms, the lender can seize the asset and sell it to recover its losses. This lessens the risk of default for lenders.

Ashley Morgan, a bankruptcy attorney in Virginia, explains: “Collateral on a secured loan means that there is property (real estate or personal property) that has a lien on it to secure the debt.”

When applying for a secured loan, the borrower agrees to pledge an asset as collateral. The lender typically assesses the asset's value to determine the loan amount they’re willing to offer. The lender evaluates the asset’s market value and typically lends only a percentage of that value, known as the loan-to-value (LTV) ratio. For example, a lender might offer 80% of a home’s value or 60%–90% of a vehicle’s value, depending on risk.

If the borrower fails to repay, the lender can legally take possession of the collateral and sell it to recoup the outstanding balance.

“It basically is another layer of protection that the lender has to ensure payment,” said Morgan. “The borrower still owns the property, but the lender just has a lien that allows them certain rights.”

Common assets used as collateral include real estate, vehicles, savings accounts, investment accounts, collectibles, business inventory and equipment. Sometimes lenders can also factor in depreciation (for cars), market volatility (for investments), and how easily the asset can be sold when determining its value.

How collateral works

Loans provide borrowers with upfront funds for major purchases or to consolidate debt. As borrowers make on-time payments, the lender recovers the loan amount and earns interest, which it can then use to fund new loans.

Collateral helps protect lenders against the risk of nonpayment by providing an additional means of recovering what’s owed. Secured loans, which require collateral, tend to have lower rates and be easier to qualify for than unsecured loans.

Lenders often want the collateral value to be close to the loan amount, though requirements vary.

“Lenders like collateral-backed loans because it’s less risky to them,” said Jeanne Kucey, CEO of JetStream Federal Credit Union in South Florida. “The borrower, however, risks seizure of their collateral if they miss their monthly payments. … There will be additional fees, a big hit to their credit score and a loss of transportation.”

Collateral creates a lien on your property, meaning the lender has a legal claim. Involuntary liens, on the other hand, come from a court order if you default.

» MORE: Secured vs. unsecured loans

Types of collateral

While collateral can include many different types of assets, common examples are:

• Business inventory
• Collectibles
• Equipment
• Investment accounts
• Real estate
• Savings accounts
• Vehicles

These types of assets are commonly used to secure loans. While mortgages and auto loans are tied to specific collateral, some personal loans can be secured by other assets, such as savings accounts or collectibles. In some cases, you may be able to use one of these assets to secure more than one loan.

However, it’s important to remember what happens to your collateral if you default on a secured loan.

“In many situations, a lender may also hold the borrower responsible for any balance after a repossession or foreclosure,” said Morgan. “These are called recourse loans because if there is any balance on the loan after the collateral is sold, the lender has the recourse to go after the borrower for the balance. If the loan is no-recourse, the lender can take the collateral only if payments are missed.

“Less common secured loans can be on personal property. For example, a pawn shop can loan on jewelry,” she added. “The pawn shop holds the property for safekeeping; if you pay the loan as agreed, you get the property back. If you do not pay, the pawn shop keeps the property and can sell it. Some banks may offer secured loans on various personal property as well.”

The table below highlights common loan types and the collateral typically associated with them.

Loan types with common collateral

Property

When you close on a mortgage, the property acts as collateral for the loan. This allows the lender to create a lien on the property, which gives them a claim to ownership until the loan is paid in full. If you default, the lender could foreclose and sell the property. This same process applies to a home equity line of credit (HELOC) or home equity loan.

» COMPARE: Top mortgage lenders

Vehicle

With an auto loan, the vehicle you're purchasing is the collateral. If you fail to make your car payments, the lender has the legal right to repossess the vehicle and sell it.

Vehicles can sometimes be used as collateral for personal loans and other types of financing, though this depends on the lender’s 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.

» COMPARE: Best car loan companies

Cash

You can pledge savings accounts, money market accounts or certificates of deposit as collateral. Your lender may require a minimum balance to qualify, though.

Investments

You can use investments in securities such as stocks or bonds as collateral for loans.

Other options

Other forms of potential collateral include precious metals, art, jewelry and valuable collectibles. But keep in mind that determining the actual market value of these items is sometimes more difficult than other forms of collateral, which can make them more difficult to use as loan security.

To use an item as collateral, it must have value. In fact, you can even pledge intangible assets as collateral if they have value. For example, you can pledge a patent or intellectual property.

Pros and cons of collateral loans

Using collateral to secure a loan may help you snag a lower interest rate and make it easier to qualify for the loan. However, the drawback is that if you don’t make timely payments, the lender may seize the asset and sell it to repay the loan.

Benefits and drawbacks of collateral loans

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