Alternative name: Sometimes, collateral is referred to colloquially as “skin in the game,” as it represents a borrower’s willingness to offer something valuable to guarantee the loan.
How Collateral Works
Collateral works as a way for borrowers to show they are committed to repaying their debt. The idea is that a borrower who has something important they might lose is more likely to make an effort to repay the loan. At the same time, the lender ends up taking on a lower degree of risk. In general, the collateral you provide must have enough value to allow for some degree of recovery for the lender. For example, a lender might not consider an item worth $1,000 sufficient value to be collateral for a loan of $100,000 or more.
Types of Collateral
When using collateral, the lender might accept different types of property as a type of guarantee against your loan. Some of the most common types of collateral include:
Real estate: Property that you own, including a home, land, or business property, can be used as collateral. Vehicle: Your equity in your car or other vehicles can be used as collateral on certain loans. The lender usually holds the borrower’s vehicle title until the loan is paid off. Jewelry or other valuable items: If you have valuable possessions, such as fine jewelry or a designer handbag, you might be able to use them as collateral for a smaller loan. Cash: A cash account can also be used as collateral. For example, you might put a smaller amount of cash into an account to secure a larger loan. In some cases, you might have a bank that will allow you to take out a loan, as long as your cash accounts at that same institution are used as collateral. Investments: Occasionally, a lender will accept the assets in an investment portfolio to secure your loan. Inventory: If you own a business, any inventory you have might be acceptable as collateral for a loan.
Examples of Collateral Loans
One of the most common examples of a collateral loan is a mortgage. When you buy a home, it is used to secure the mortgage. If you don’t make your payments, the lender can foreclose on your home and you could lose the house because the lender will repossess and sell the home to recoup some of the money it gave you. Another example of a collateral loan is an auto loan. When you get a loan to buy a car, the lender can repossess the vehicle if you miss payments. Pawnshops also offer collateral loans. You bring in a valuable item, it’s appraised and the pawnshop owner acts as a lender, advancing the funds. If you repay the loan, you receive your item back. If you don’t repay the loan, you lose the item and the pawnshop owner can sell it to try to get back the amount lent. Even secured credit cards are collateral loans. For example, if you get the Secured Mastercard from Capital One and make a $49 deposit, you can get a credit line of $200. If you default, Capital One will keep your deposit.
Pros and Cons of Collateral Loans
Unsecured loans that don’t require any collateral are sometimes an option when borrowing, but as the lender takes on more risk, that generally translates to higher interest rates and less favorable loan terms. You may find that putting an asset down as collateral is more beneficial than the extra money you’ll pay in interest.
