What is collateral?

How collateral works

Personal loans provide upfront funding for borrowers to use for a number of purposes — like home improvement projects, for instance, or consolidating credit card debt. As the 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.

But there’s a 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.

Loans that require collateral are called secured loans. If a borrower defaults on a loan (meaning they miss payments or stop making payments altogether), the lender can take possession of the collateral and sell it to regain the loss. A lender may require the collateral value to be as equal to the loan value as possible, although this requirement varies depending on the lender’s policies.

“Lenders like collateral-backed loans because it’s less risky to them,” said Jeanne Kucey, the CEO of JetStream Federal Credit Union. “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.”

Types of collateral

You can use many different types of assets 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 you pay the loan 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.

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. You can use cars 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.

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. Determining the actual market value of these items is sometimes more difficult than other forms of collateral (like cash accounts), which can make it more difficult to use them as loan security.

What you can’t use for collateral

Most lenders do not allow the use of retirement accounts, such as 401(k)s and individual retirement accounts (IRAs). Additionally, some lenders may not accept vehicles over a certain age as collateral for an auto loan.

» MORE: Secured vs. unsecured loans

Examples of collateral loans

Secured loans may be more common than you realize, including some of these examples of popular collateral-backed loans:

• Mortgages: When you take on a mortgage, the home you’re purchasing is the collateral. If you default on the loan and no longer make the payments, the home or property sells through the foreclosure process.
• Home equity loans and HELOCs: Similar to mortgages, home equity loans and HELOCs use your home as collateral. You borrow either a lump sum for the equity loan or the line of credit, but defaulting on these loans results in foreclosure.
• Auto loans: Borrowers use auto loans for the purchase of a vehicle. If you default on the loan, then the lender can repossess the vehicle.
• Secured credit card: A secured credit card works similarly to an unsecured credit card but requires a security deposit when establishing a credit line. Typically the amount of the credit limit equals the security deposit.
• Car title loans: These risky short-term loans use your car title as collateral. If you default on a title loan, it results in repossession of your vehicle. This is in addition to the exorbitant interest fees associated with the loans, making these loans illegal in several states.

» MORE: How to stop foreclosure

Pros and cons of using collateral for a loan

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. While there are a few companies that offer secured personal loans, most personal loans don’t have a collateral 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.