Collateral is any asset that a lender takes as security for a loan. This can be in the form of real estate, physical assets like a car, and more, depending on the loan and lender. Collateral serves as protection for the lender, minimizing some of their risk. If the borrower defaults on their payments, lenders can seize the asset and sell it, recovering some of the losses.
Lenders always want to know you can pay back a loan, and collateral offers them a sense of security. Through collateral, lenders have a legal claim to the borrower’s asset(s), and that claim is called a lien.
A loan secured with collateral usually has much lower interest rates than unsecured loans.
Types of Collateral
When taking out a loan on a home, like a single family rental, or a piece of commercial property, the property itself serves as collateral. If you’re unable to make mortgage payments, the bank that issued the loan has the right to seize and sell your property, often as a foreclosure or short sale.
A vehicle loan works in the same way as a property loan. If you’re unable to make car payments, the vehicle can be seized.
Bank Savings and Investment Accounts
Some personal loans will accept the money in your savings or investment accounts as collateral. In the event you fail to make the loan payments, the lender can then take the money directly from your savings and investments.
For very short-term loans, you can sometimes use future paychecks as collateral. These loans typically last one to two weeks and are issued in emergency situations.
Items of Value
For collateralized personal loans, some lenders will accept items of value as collateral. This could include any valuable item you own, from jewelry to furniture. For this type of loan, it’s best to use a financial institution you trust.
Example of a Collateral Loan
Loans on commercial real estate properties are almost always secured with collateral. For instance, if you purchase a $10M property — putting in a downpayment for $1M and taking out a loan for the rest — the property itself serves as collateral.
If you default on loan payments, the bank can then seize the property and sell it, keeping the money and putting it toward the remaining payments.