What is Collateral?
A common term when it comes to loans and lines of credit is collateral. If you’re interested in getting any type of financing that requires collateral, it’s important to fully understand what the term means. This guide will cover the definition of collateral, common forms of it and what happens to this collateral if a default occurs.
Types of Financing
You could break down all forms of financing, including both loans and lines of credit (which include credit cards), into the following two categories:
- Secured financing
- Unsecured financing
The only thing separating these two types of financing is the presence of collateral. A secured loan or line of credit must have some property of the borrower’s attached as its collateral. The lender can then legally repossess that property if the borrower fails to make their payments. An unsecured loan or line of credit only has the borrower’s personal guarantee that they’ll pay back what they borrow.
Common Forms of Collateral
There are many different pieces of property that a borrower can use as collateral on a loan or line of credit, although the collateral will depend on the lender and what that lender offers.
The two most common items that borrowers use as collateral are their homes and their cars, and the reason for this is that these are typically the most valuable items that a person will own.
It’s important to understand that there are multiple ways property could become collateral on a type of financing. If the borrower buys that property with a loan, then the property is automatically the collateral on that loan until the loan is paid off. A home is automatically the collateral on the mortgage used to purchase it, and a vehicle is automatically the collateral on a vehicle loan.
The borrower could also use property they’ve already purchased as collateral to secure financing. For example, someone with a paid-off car could use it as collateral to get a title loan. Or, someone who has paid into their home and has equity in it could use that equity to get a line of credit.
Although credit cards usually don’t have collateral, there are secured credit cards intended for those with bad credit. In this case, the cardholder pays a security deposit, and the money they pay is the collateral.
What Happens if the Borrower Defaults
The simple answer here is that if the borrower defaults on a secured loan or line of credit, the lender will repossess the collateral. In practice, it usually goes more like this:
- The lender waits a certain period of time after the payment due date in case the borrower is just late on their payment.
- The lender notifies the borrower of the missed payment and explains the possibility of repossession if the borrower doesn’t catch up on what they owe.
- The lender waits again to see if the borrower will pay.
- If the borrower doesn’t make their payment, the lender will initiate the repossession process.
Now, this process varies quite a bit depending on the situation. A mortgage may have a long, drawn-out repossession process, whereas with a title loan, repossession could happen the day of the default.
Collateral can be an excellent way to receive approval on a loan. Just keep in mind that whatever you put up as collateral will be at risk if you fail to hold up your end of the bargain on the loan.