Credit: Binyamin Mellish via Pexels
You’re applying for a new loan and the provider informs you that in order for the application to get approved, you will need to offer a form of collateral. What does that mean?
Collateral is just one of the many important loan terms to know before you go searching for borrowing options. “Collateral” is a valuable asset that a borrower pledges in their loan application. The asset can be a piece of real estate, a vehicle, a cash deposit or an investment.
Find out more about the term collateral below.
Why Do Providers Ask for Collateral?
Providers tend to require collateral for large loans to mitigate the risk of late payments or loan default. By pledging the asset, the borrower is likely to take the loan repayment process more seriously than if they hadn’t pledged an asset at all. This is because the borrower will want to maintain their asset. If they make the mistake of defaulting on the loan, the provider essentially gets to seize the asset in order to recoup any losses that resulted from that default.
Providers also may ask for collateral to compensate for the fact that a borrower doesn’t meet other loan qualifications. For instance, if the borrower doesn’t have a good credit score, offering up a form of collateral could convince the provider to approve the loan. The asset provided will offset the risk that comes with a lower credit score.
Think of collateral as a form of insurance for a provider. It is a safety net to protect them in the worst-case scenario (default).
The Benefit of Collateral
Collateral can help you get approved for a large or previously unattainable loan. It also tends to result in a benefit you may not have expected: lower interest rates.
Secured loans (loans using collateral) typically come with lower interest rates in comparison to unsecured loans (loans without collateral). This is because interest rates are often used to encourage loan repayment and mitigate the risk of default. So, since collateral already minimizes the risk of default, the interest rates attached to secured loans are typically low.
What Types of Loans Require Collateral?
Whenever you buy a new car, you will need to take out an auto loan. The car itself acts as collateral in this agreement. So, if you default on the loan, there is a possibility that the car will be repossessed. Once you complete the loan, the car is no longer considered collateral — it is your asset.
When you decide to buy a house, you will need to apply for a mortgage loan. In a mortgage loan, the house is the asset used as collateral. So, if you default on the loan, the provider could start the foreclosure process and you could lose your house.
Home Equity Loans
A home equity loan is only available to homeowners who have built up home equity over time. Home equity is the difference between the home’s value and what remains of the mortgage. The homeowner can essentially use that equity as a borrowing tool, either in the form of a home equity loan or a home equity line of credit (HELOC).
Much like a mortgage loan, defaulting on a home equity loan could result in losing your house.
Secured Credit Cards
The average credit card is not secured. You do not have to offer a form of collateral in order to access this type of account. You will have to meet other qualifications, like a good credit score and a steady stream of income.
Secured credit cards are an option for borrowers who can’t get an unsecured credit card (often because of their current credit score). With a secured credit card, you can use a cash deposit as a form of collateral.
So, are you willing to use collateral to get the loan that you want? The benefits could just outweigh the risks.