Collateral is any asset which is pledged to a lender in exchange for receiving a personal loan or other form of credit from that lender. If the borrower fails to repay the loan under the agreed terms and the loan goes into default, the collateral then belongs to the lender. Loans which are secured by collateral are sometimes called secured loans.
Why use collateral?
In some cases, a borrower may opt to secure a personal loan with collateral in exchange for a lower interest rate. For borrowers with poorer credit, a loan may not even be available unless it is secured by collateral.
What can be used as collateral?
The asset used as collateral must be something tangible which has value to the lender as well as the borrower. This includes financial certificates for bonds and other savings, the expected future value of an investment, and physical things such as houses, cars, or jewelry. For example, a future crop can be used as collateral. However, the likely increase in earning power of a college-educated student is not something which has monetary value to the lender, so student loans are not usually secured loans. The choice of collateral must be acceptable to both lender and borrower.
How much collateral will you need?
The value of the collateral is comparable to the risk of the loan, as well as the liquidity, current market value, and likely future market value of the collateral. The risk that the loan will not be repaid is called contract risk.
The purpose of the loan also affects contract risk. Personal loans used to finance investments such as term deposits are secured by those investments. Personal loans used to finance stock market investments are more risky than loans used to finance major assets such as cars or houses. In fact, investors who buy shares on margin are required to maintain a margin account based on a percentage of the equity of the stock. If the stock price goes down, investors may need to sell some of their shares or otherwise make up the difference to maintain the required amount of collateral. If this happens on a large scale as the result of a market decline, this may have the effect of driving the share value down further.
Cars can be resold, but they steadily lose market value. A new car can usually be financed up to its current market value, but older cars soon lose their value as collateral. Special types of car financing loans called balloon loans offer lower payments, but expect you to come up with the expected market price of the car at the end of the financing period.
If you own your own house, consider using it as collateral for a mortgage instead of taking out a standard personal loan. The interest rates are usually much lower. If market value in your area is stable and you are a good credit risk, a mortgage financier may be willing to lend up to the full market value of the house. However, if the market value of your house falls, you may find yourself owing more than the house is worth, a condition known as being underwater. This is a risk to the bank as well as to the borrower. In regions where borrowers are protected by anti-deficiency laws, foreclosure may not be enough for a lender to recoup the value of the mortgage. For this reason, when the market value of real estate is falling, mortgage lenders may be reluctant to offer mortgages at all.
Pawnshops are lenders of last resort for low income borrowers with poor credit. The risk of default is high. Additionally, the types of items brought in as collateral may not sell very quickly. For these reasons, personal secured loans offered by pawnshops are typically 10% or less of the market value of the collateral.
What happens to collateral during a loan?
The asset being used as collateral may be held physically by the lender until repayment of the loan. Some car financing companies hold the title of the car being financed until the loan is paid off. Pawnshops loan money against collateral of jewelry or other portable valuables, which they will return upon full repayment of the loan plus interest.
Alternately, the lender does not take possession of the asset, but retains the right to seize it in case of default. If you have a mortgage, you may use the mortgaged house as your own for all purposes except demolishing or selling. However, if the borrower falls too far behind in the mortage, the lender issuing the mortgage will foreclose on the house, and the borrower will be evicted.
Regardless of whether collateral is in the lender’s or the borrower’s possession, the lender has a controlling interest in the asset being used as collateral. This limits what you can do with property which is being used to secure a loan. For example, a mortgaged house cannot be sold without the approval of the company holding the mortgage. This claim remains in force until the loan is fully paid off.
What happens in case of default?
If a loan secured by collateral goes into default, the lender becomes the new owner of the collateral. Regardless of the amount remaining on a loan at the time of default, the lender receives the full value of the collateral. If the current value of the collateral is insufficient to cover the debt, any remaining debt is called a deficiency. Depending on local anti-deficiency laws, you may be protected against having to make up the difference. This is most common with mortgages. Otherwise, you will be responsible for making up the difference.
Although mortgage foreclosures have been making the news, the most common deficiencies occur when financed cars are totaled in car accidents. Any insurance money may not be enough to pay off the amount still owing on the car, let alone purchase a new one.