Collateral

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What is collateral?

Collateral is an asset or a property that a borrower provides to a lender to secure a loan.

Because lending money is risky, a lender may require that a borrower put up an asset, such as a house, a car, or other valuable personal property, that can be seized by the lender if the borrower fails to pay back the loan.

Secured vs. Unsecured loans

Not all loans require that the borrower offer collateral. A loan that does not require collateral is called an “unsecured loan.” Examples include:

  • Credit cards
  • Medical bills
  • Utility bills
  • Other services that are provided before payment

A loan that does require collateral is called a “secured loan.” Examples include:

  • Home mortgages
  • Auto loans
  • Some personal and business loans
  • Pawnshop loans

Typically, the value of collateral property must equal or exceed the amount of the loan being requested.

Security and interest rates

Because collateral offers the lender a degree of security, interest rates charged on secured loans are often much lower than for unsecured loans.

Average Interest Rates
Unsecured Loan: Credit Card Secured Loan: 30-Year Mortgage
16.35% 4.3%

 

Mortgage collateral

Collateral for a mortgage is the home that is being purchased with the loan.

To take out a mortgage, a borrower has the property appraised to determine its “fair market value.” The lender agrees to provide a loan equal to or less than the appraised value. In exchange, the borrower puts up the property as collateral.

The borrower agrees to make on-time payments of a specified amount to the lender. If the borrower misses too many payments, the lender can begin the process of taking possession of the property, which is called “foreclosure.”

If borrowers are able to make up missed payments within a specified period, they may be able to retain ownership of the property. Otherwise, the lender seizes the property and can sell it at auction to recover some of the money lost on the loan.

HELOC

A residential property can also be used as collateral for another type of secured loan: a “home equity line of credit,” or “HELOC.”

If homeowners have already paid off a large portion of their mortgage, they have “equity” in their home. If they need cash, they can take out a HELOC loan equal to the amount of that equity.

Funds borrowed under a HELOC loan can be used for any purpose.

For example:

You take out a mortgage to purchase a home worth $200,000.

After several years, the remaining mortgage balance is $120,000.

Therefore, you have $80,000 in home equity.

You need to access $45,000 to pay medical bills.

If approved, you can use the equity in your home to borrow up to $80,000 from the lender through a HELOC loan.

You borrow $45,000 to pay your bills.

You must now repay the remaining $120,000 mortgage balance and the $45,000 borrowed under the HELOC plus interest.

If you fail to pay, the lender can foreclose on your property.

Fun facts

  • The soccer team Real Madrid put up two of its players, Cristiano Ronaldo and Ricardo Izecson dos Santos Leite, as collateral for a loan to finance the purchase of their contracts. If the team fails to repay the loan, the players’ contracts will pass to the Central Bank of Europe.
  • Other items used for loan collateral have included pets, valuable show or race animals, patents, and wheels of expensive cheese.

References

  1. https://www.investopedia.com/terms/c/collateral.asp
  2. https://www.investopedia.com/terms/u/unsecureddebt.asp
  3. https://www.thebalance.com/the-difference-between-secured-and-unsecured-debts-960181
  4. https://www.thebalance.com/collateral-loans-315195
  5. http://www.bankrate.com/finance/credit-cards/current-interest-rates.aspx
  6. https://www.bankrate.com/finance/mortgages/current-interest-rates.aspx

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