how collateral works
before a lender issues you a loan it wants to know that you have the ability to repay it that s why many of them require some form of security this security is called collateral which minimizes the risk for lenders by ensuring that the borrower keeps up with their financial obligation the borrower has a compelling reason to repay the loan on time because if they default they stand to lose their home or other assets pledged as collateral loans secured by collateral are typically available at substantially lower interest rates than unsecured loans a lender s claim to a borrower s collateral is called a lien a legal right or claim against an asset to satisfy a debt in the event that the borrower does default the lender can seize the collateral and sell it applying the money it gets to the unpaid portion of the loan the lender can choose to pursue legal action against the borrower to recoup any remaining balance types of collateralthe nature of the collateral is often predetermined by the loan type when you take out a mortgage your home becomes the collateral if you take out a car loan then the car is the collateral for the loan the types of collateral that lenders commonly accept include cars only if they are paid off in full bank savings deposits and investment accounts retirement accounts are not usually accepted as collateral you also may use future paychecks as collateral for very short term loans and not just from payday lenders traditional banks offer such loans usually for terms no longer than a couple of weeks these short term loans are an option in a genuine emergency but even then you should read the fine print carefully and compare rates another type of borrowing is the collateralized personal loan in which the borrower offers an item of value as security for a loan the value of the collateral must meet or exceed the amount being loaned lenders will typically lend only a percentage of the collateral s value not 100 of its value if you are considering a collateralized personal loan your best choice for a lender is probably a financial institution that you already do business with especially if your collateral is your savings account if you already have a relationship with the bank that bank would be more inclined to approve the loan and you are more apt to get a decent rate for it use a financial institution with which you already have a relationship if you re considering a collateralized personal loan examples of collateral loansa mortgage is a loan in which the house is the collateral if the homeowner stops paying the mortgage for at least 120 days the loan servicer can begin legal proceedings which can lead to the lender eventually taking possession of the house through foreclosure 1 once the property is transferred to the lender it can be sold to repay the remaining principal on the loan a home may also function as collateral on a second mortgage or home equity line of credit heloc in this case the amount of the loan will not exceed the available equity for example if a home is valued at 200 000 and 125 000 remains on the primary mortgage a second mortgage or heloc will be available only for as much as 75 000 collateralized loans are also a factor in margin trading an investor borrows money from a broker to buy shares using the balance in the investor s brokerage account as collateral the loan increases the number of shares the investor can buy thus multiplying the potential gains if the shares increase in value but the risks are also multiplied if the shares decrease in value the broker demands payment of the difference in that case the account serves as collateral if the borrower fails to cover the loss 