Collateral

Collateral: Definition, Types, and How It Works

Key takeaways

• Collateral is an asset pledged to secure a loan; it reduces lender risk and often results in lower interest rates.
• If a borrower defaults, the lender can seize and sell the collateral to recover losses.
• Common collateralized loans include mortgages, auto loans, home equity loans, and margin loans.

What is collateral?

Collateral is any asset a borrower pledges to a lender as security for a debt. It gives the lender a legal claim (a lien) on the asset so the lender can seize and sell it if the borrower fails to repay. Typical examples are homes, vehicles, bank deposits, and investment accounts.

How collateral works

• Before approving a loan, a lender assesses the borrower’s ability to repay and the value of any pledged collateral.
• Because collateral reduces lender risk, secured loans typically carry lower interest rates than unsecured loans.
• Lenders usually advance only a portion of an asset’s value (borrowers rarely receive 100% of collateral value).
• If a borrower defaults, the lender may repossess or foreclose on the collateral and sell it to cover the outstanding debt. If the sale doesn’t cover the balance, the lender can pursue the borrower for the shortfall.

Common types of collateral

• Real estate: Primary collateral for mortgages and second mortgages (HELOCs/home equity loans).
• Vehicles: Collateral for auto loans; lenders can repossess a car for nonpayment.
• Cash and deposit accounts: Savings or certificates of deposit can secure loans.
• Investment accounts: Brokerage balances can be pledged or used in margin trading.
• Business assets: Equipment, inventory, or commercial property can secure business loans.
  Notes:
• Retirement accounts are generally not accepted as collateral.
• Short-term loans may use future paychecks as collateral in some circumstances.

Collateralized personal loans

A collateralized personal loan uses an asset you own to secure borrowing. Lenders typically:
* Limit the loan amount to a percentage of the collateral’s appraised value.
* Favor borrowers with an existing relationship (e.g., your bank) when evaluating collateral like savings accounts.
Always compare offers and read terms closely—especially for short-term or emergency loans.

Examples

• Mortgages: The home secures the loan. Failure to pay can result in foreclosure and sale of the property to satisfy the mortgage.
• Home equity loans/HELOCs: A second lien uses remaining home equity; available borrowing equals the home’s value minus the primary mortgage balance.
• Auto loans: The vehicle is collateral and may be repossessed for default.
• Margin trading: Investors borrow from brokers using their brokerage account balances as collateral; declines in value can trigger margin calls or liquidation.

Frequently asked questions

Q: Do I get my collateral back?
A: Yes—if you meet all loan obligations and do not default, you retain ownership of the collateral. If you default, the lender can seize and sell it.

Q: What loans don’t use collateral?
A: Unsecured loans, such as most personal loans and credit cards, do not require pledged assets.

Q: Is collateral always physical property?
A: Not always. Cash, deposit accounts, and investment account balances can also serve as collateral.

Q: What happens if the sale of collateral doesn’t cover the loan?
A: The lender may pursue the borrower for the remaining balance through legal action, depending on the loan terms and local laws.

Bottom line

Pledging collateral can lower borrowing costs and help access larger loans, but it increases the stakes: failure to repay can mean losing valuable property. Before using an asset as collateral, understand how much you can borrow, the lender’s rights on default, and alternative unsecured options.