Collateral is a valuable item or an asset a person or a business provides for a financial organization as a security when taking a loan. A financial institution has a legal right (called a lien) to take collateral (this process is called repossession) if the borrower cannot repay the loan, and sell it to cover its expenses. Different types of collateral exist, and in most cases the needed type of collateral depends on the type of debt.
How collateral is used
It might be risky for a financial institution to provide a loan, that’s why an idea of collateral was introduced: it minimizes the danger of losing all funds in case a borrower doesn’t pay back. Firstly, the collateral guarantees that a borrower owns enough to be able to repay the debt. Secondly, the collateral is used directly as a pledge, and it’s documented when issuing a loan. By doing so, a loan issuer is more protected from the losses, because the borrower is motivated in paying off the debt to remain the owner of the collateralized items. If the borrower fails to pay the loan back, the collateral for this loan legally becomes property of the loan issuer, and it may be sold or used any other way to make up for the losses. The loan issuer is also able to appeal to the court if the collateral is not enough for covering its expenses.
When preparing for issuing a loan, a financial organization usually evaluates and studies the possible collateral, because typically it must be of equal or greater value to the requested amount of the loan. If the value of the collateral doesn’t correspond to the needed sum, the financial organization has a right not to accept it and doesn’t provide a credit, accordingly.
Advantages and disadvantages of collateral secured loans
When talking about advantages, it’s important to remember that a financial institution providing a loan is protected to some extent by the collateral, that’s why it usually offers lower interest rates for such loans, and sometimes a larger sum of credit is available under the condition of providing collateral. This is the main advantage of the use of collateral secured loans. The fact of owning collateral also might help a person or an organization with a poor credit score to get a loan of some sort, which is another significant advantage.
Concerning disadvantages, there is one obvious thing about collateral — there’s a possibility of losing property in case the borrower defaults and is unable to pay back. But there is one more thing to remember about when considering a collateral secured loan - depending on the type of collateral, the purposes of such loans might be restricted to several areas only.
Most commonly used collateral loans
As it was stated above, the kind of collateral is closely connected with a type of loan it is used for. Let’s examine it by using the examples of the most common collateral loans - a mortgage and a car loan.
A mortgage is a kind of loan in which the house or other type of real estate serves as collateral. And in case the borrower fails to pay off the loan, the house is taken by the loan issuing organization and is sold to pay off the debt.
A car loan is often issued similarly, when means of transport bought with the help of the provided loan is used as collateral and again might be repossessed and sold if the debt isn’t paid in full.
Main types of collateral
Though mortgages and car loans are the most well-known, other types of loans, which might be collateralized, also exist. Most of them are non-specific and individual, so it’s worth to examine more probable assets that might serve as collateral.
It’s possible to divide them into the following groups:
- Houses, land, and other kinds of real estate serve as collateral for mortgage, which was examined above.
- Motor vehicles are usually used as collateral for car loans, also studied in the previous paragraph.
- Jewelry, precious metals and other valuable objects also frequently serve as a collateral for smaller, personal loans, if their value equals the needed sum.
- Cash deposits are sometimes used as collateral, most frequently it happens when a cash account is collateral for a bigger loan in the same financial organization. It’s important to know, though, that retirement accounts aren’t usually accepted for such purposes.
- Investments and intellectual properties are sometimes possible to use as collateral too, but conditions for such loans might be different from one organization to another.