Anyone who has ever taken a big loan out - think mortgage, small business or auto loan, for example - likely knows the meaning of collateral.
What Is Collateral?
Strictly speaking, collateral is the asset or assets pledged by a borrower to back up a request for a loan. If the borrower gets the loan and fails to repay it, the lender has the right to seize the asset (i.e. collateral) to make up for the lost income.
In the real world, collateral works like this:
You seek out a small business loan for $50,000. When you apply for the loan, a lender may well ask you to put up $50,000 of collateral against the loan request. That collateral could come in myriad forms - a home, an investment portfolio - even expensive jewelry, rare coins, or a valuable painting.
If you repay the loan based on the terms of your agreement with the lender, you won't have to use your loan collateral. If you default on the loan agreement, the lender can take your collateral and use it to recover losses incurred by the defaulted loan. That claim to the borrower's collateral is known in the finance world as a "lien."
Contrary to consumer belief, collateral can be a valuable asset for borrowers, too.
If a borrower provides an ample amount of collateral against a loan, the lender often lowers the rate of interest on that loan, as the collateral is substantial, and the loan thus becomes less risky for the lender. That scenario would result in the loan borrower saving money on loan interest, and ultimately lead to lower payments on the loan.
Or, consider a borrower with low credit, but who is seeking a loan.
In that event, the collateral provided, if deemed as sufficient by the lender, could boost the chances of the loan being approved. Lenders view collateral as the commitment the borrower is willing to make (and pay) to secure a loan or credit.
That reduces the risk taken by the lender, and puts a borrower with low credit in a better position to get a loan or credit, as long as he or she puts down enough collateral.
How Collateral Is Structured
The type of collateral required by a lender depends on the type of loan.
For instance, the type of collateral on a mortgage loan may be fixed, while the collateral on a personal loan may be flexible and can be negotiated.
In the event of a mortgage loan, the collateral on the loan is virtually always the home and property itself. If the homeowner defaults on the loan, the lender can take the home in a process called foreclosure, with the ownership of the loan reverting to the lender, who will likely sell the home to recoup the assets lost on the defaulted loan.
Collateral on other common loans are different. For example, in the investment world, brokerage companies can offer loans to clients called "margin loans", which gives the client the assets needed to buy a security that he or she otherwise couldn't afford.
To get a margin loan, the client has to put up securities he or she already owns as collateral. If the client doesn't pay the margin loan back, the broker can take the securities under collateral, and resell them to earn back the money they lost on the margin loan. In many cases, the broker doesn't even have to tell the client that it's taking the securities away - it can do so at any time, with no prior notice to the margin loan borrower.
Alternatively, some forms of financial loans require no physical collateral.
Take credit cards, for example. When you are approved for a credit card, which technically is a loan, as the card provider guarantees payment when purchases are made on the credit card.
Still, no collateral is required. Instead, the credit card provider will seek it' "insurance policy" through a higher-than-average interest rate charged on the card, which is substantially higher than the interest on a mortgage loan or student loan, for example.
Let's break down the collateral, in any form, that is commonly included in any consumer loan scenario:
- A mortgage loan. With a mortgage loan, the collateral is the home/property that the borrower is purchasing.
- An auto loan. Like with a mortgage loan, the collateral on auto loan is the vehicle the borrower is buying.
- A secured credit card. With secured credit cards, which are usually used by consumers with no or low credit, the collateral is a cash advance paid ahead of time by the card user. Almost always, that cash advance represents the amount of credit granted to the card user. For example, if the cash advance on a secured credit card is $300, the amount of credit bestowed on the credit card user is also $300.
- A personal loan. With a personal loan, the collateral can vary and can be negotiated. For instance, the collateral on a personal loan may be the borrower's home, vehicle, investment portfolio, or bank account.
- A margin loan. The collateral on a margin loan is usually securities held by the brokerage company client who is taking out the margin loan.
- A small business loan. Small business loan collateral may vary, based on the agreement reached between a lender and a borrower. For instance, agreeable collateral might include real estate property, business equipment, inventory, or even payment from clients that hasn't been received yet. A business owner can also use his or her personal assets as credit, as well.
Three Tips on Leveraging Collateral to Get a Loan
Consumers do have some leverage when it comes to providing loan collateral. Try these tips to better your chances of getting a loan or credit, and at a lower interest rate.
1. Keep Good Records
To squeeze the most opportunity from your loan collateral, make sure to keep thorough records of the assets in question (like a home or a valuable piece of jewelry.) The more detail you can provide on loan collateral - especially pertaining to its value - the better your odds of securing the loan, and at a lower interest rate.
2. Get an Appraiser
If you're unsure about the value of an owned asset, go ahead and hire a professional appraiser to assess the value of the asset in question. For example, if you're considering putting up a diamond ring as collateral for a loan, take it to a respected jewelry expert to officially ascertaining its value. Make sure to get the appraisal in writing.
3. Understand the Risks Involved
Yes, the risk of losing your collateral is the primary risk in obtaining a loan or credit - but it's not the only risk.
For instance, your credit score could suffer if you default on a loan, and that makes getting good credit at lower rates more difficult to accomplish. Additionally, if you lose stocks, bonds or funds via a defaulted loan, you not only lose the securities, but you lose the future value of those securities when they rise in value after they leave your portfolio.
It's always a good idea to talk with a trusted financial adviser before agreeing to provide collateral for any loan. He or she can walk you through the risks associated with loan collateral.
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