Collateral

Collateral summary:

• Common examples of collateral are cars, homes, and bank account balances. 

• Lenders may require collateral if you’re borrowing a lot, if you’re borrowing against equity, or if you’re having trouble qualifying otherwise for a loan.

• A loan with collateral is called a secured loan. 

Collateral Definition and Meaning

Collateral is a term that lenders use to describe something of value they could legally take if you don’t repay your loan. For the lender, collateral lowers the risk of loss. Collateral is like a “Plan B” to secure repayment. 

Not all loans require collateral, but if yours does, it’s something that you and your lender agree on upfront in your loan agreement. 

Examples of Collateral

Lenders usually require collateral in three cases:

• If you’re buying an asset (i.e., something of significant value)

• If you’re borrowing against equity (the value of something you already own)

• If you’re having trouble qualifying for an unsecured loan (one that doesn’t require collateral)

Let’s look at a couple of examples of how this works. 

Collateral example: Buying a vehicle

When you borrow to buy a car, your lender will typically use the vehicle you’re buying as collateral for that same loan. 

Let’s say you take out a car loan for a new truck. That truck will be the collateral for the loan. If you don’t repay the loan, the lender can repossess your truck to repay the debt. In other words, they can take the car and sell it. 

But if you make all of your payments on time until the loan is paid off, nothing unusual happens. You might not even remember that your truck was collateral until the loan was paid off. 

Collateral example: Taking out a home equity loan

Some lenders will let you borrow against an asset you already have, like with a home equity loan. In that case, your home itself will be the collateral. If you took out a mortgage to buy the home, your home was collateral for that loan (and it still is if the loan isn’t paid off yet). Your home could be the collateral for a primary mortgage and a home equity loan at the same time. 

Here’s an example. Let’s say you own a home free and clear of any mortgage and you want a home equity loan. If you don’t repay your home equity loan, your lender could foreclose on your home. The lender could sell your home to repay the debt and write you a check for any extra money left over. But again, if you pay off your debt as planned, you won’t really notice anything different from other loans.

Collateral example: Qualifying for a moving loan

Lenders often set specific requirements to get a loan, and it’s not always possible to meet those expectations. It’s not necessarily your fault—that’s just how life works sometimes. In that case, the lender might allow you to pledge something as loan collateral in order to qualify for the loan. They might accept a certificate of deposit account or another vehicle you own as collateral.

Consider this example. You want to take out a personal loan to pay the rental deposit on a new apartment, but you don’t qualify for approval. You find a lender that allows you to pledge your brokerage account balance as collateral for the loan in exchange for being approved. If you default on the loan, your lender could take the money from your investment account. If you repay the debt as agreed, you’ll get the full use of your investment account balance again.