What Is Collateral and How Does It Work?

What Is Collateral and How Does It Work?

If you ever had a car loan or mortgage, then you would have probably heard about the term “collateral”. It’s one term that lenders love and it’s prevalent in the lending world. Read on to learn “what is collateral” and how it helps obtain a loan.

What Does Collateral Mean?

Collateral is an asset of value that is given to the lender as insurance in case the borrower fails to repay the loan. Wikipedia defined collateral as “a borrower’s pledge of a specific property to a lender, to secure repayment of a loan.” The collateral serves as security and helps reduce the lender’s risk in a loan deal. For instance, if someone takes a loan from a bank using a house as collateral and defaults in their repayments, the bank has the legal right to seize the house and sell it to make up for the loan. Collateral is usually associated with secured loans; it reduces the associated risk for the lender.

What Qualifies as Collateral?

Not every item can serve as collateral. For something to be considered as collateral for a loan, it must have a value that is equal or higher than the amount of the loan. The value here is the monetary value of the said item when sold. For instance, you can’t go to take a $300,000 loan and offer a laptop as collateral. The market value of the PC is far lower than the loan amount. So even if you refuse to pay the loan, the lender cannot recoup the loan amount by selling the laptop.

How Collateral Can Help You

Collateral is an invaluable tool in the lending world. It comes in handy to serve as relief when a lender is skeptical about giving out a loan. Loan deals of massive amounts would typically not go through without good collateral. It serves as security and reduces the risks the lender face by giving you a loan. The collateral also reduces loan eligibility requirements. People with poor credit history whose loan applications would typically be declined would be allowed access to loan facilities.

Examples of Collateral

You can use anything of value as collateral for a loan. It could be a tangible asset (physical items) or intangible assets. Tangible assets that can serve as collateral include house, buildings, car, land, stationary, etc. Intangible assets are items of value which cannot be seen or touched. It includes copyright, investments (shares, options, etc.), payment right, account receivables, etc. Other valuable items like jewelry, paintings, and others can also be accepted as collateral. Some businesses use their account receivable, which is the money owed to them by other people or businesses as security for loans.

How the Collateral for a Loan Is Determined

The collateral for a loan would depend on the type of loan and the amount. There are only two types of loans; secured and unsecured. Unsecured loans don’t require any collateral. Here the lender gives out the loan, based on the borrowers promise to pay back. Secured loans, on the other hand, require collateral. Below are examples of collateral loans.

Personal Loans

A personal loan is used by consumers to pay for small expenses, consolidate existing debt, or build a credit score. It is usually unsecured; however, when the amount is enormous, lenders may require collateral. Since the collateral reduces the risk associated with the loan, the interest rate of secured personal loans is usually lower than unsecured loans. Also, the eligibility requirement is relaxed. Lenders would care less about your credit score. Assets like houses, vehicles, jewelry, and monetary assets like shares, payment rights, and others can be used as collateral for a personal loan.

Small Business Loans

A small business loan is taken by a business to fund their operation or expansion. Typically banks and other financial institutions will be reluctant to loan substantial amounts to such small firms without collateral. The collateral for a business loan can be an asset of same or higher value monetary to the loan amount. It could be business assets like equipment, vehicles, land, or building. Alternatively, the business owner can use their asset to apply for the loan, if the business has no asset of great value.

Mortgages

A mortgage is a loan taken to either purchase a new house or refinance an existing mortgage loan. It’s usually secure by nature. They are secured on the home which was purchased with the loan. This means that the lender would own the house until the loan repayment is completed. If the borrower defaults in paying a mortgage, the bank or financial institution can begin the process of foreclosure. The process transfers the ownership of the home to the lender, who can then resell it to earn back the loan amount.

Auto Loans and Collateral Title Loans

An auto loan provides money for you to buy your dream car. A title loan can get car collateral loans on your car title for cash. In both cases, the underlying asset (the vehicle) is used as collateral for the loan. Just like mortgages, the lender would hold a lien on the car until the loan is fully repaid. The vehicle can also be repossessed if the borrower fails to repay the loan.

Tips on Using Collateral for Loans

Provide adequate records

A lender wouldn’t just agree with your valuation of an asset. You have to show documents to prove its current value. For instance, a borrower’s assessment of a home and that of the lender may differ. When this happens, you can either provide an overly convincing document or get a revaluation. Get an appraiser to perform an expert review of the property and declare a value that will be accepted by both parties. Items such as jewelry, homes, cars, et are complicated to value, hence the need for an appraiser.

Understand the Risks Involved

You stand a chance of losing the asset used as collateral if you fail to repay the loan. Whether it is a house, vehicle, building, or investments like shares, bond, and options, you will lose all of it to the lender. This makes it necessary only to take loans you can repay. Besides losing your property, defaulting on a loan also lowers your credit score.

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