Collateral

Before you rely on it

What to check

Identify exactly which asset is pledged, and whether the security reaches anything beyond it.

The common error

Where people go wrong with collateral

Missing a cross-collateralisation clause. A loan secured against one vehicle can be written so that a default reaches others held at the same institution, and borrowers find that out late.

Worked through

Collateral in plain numbers

You borrow $20,000 to buy a car worth $25,000, and the lender takes the car as collateral. If you stop paying, the lender can repossess it and sell it to recover what is owed. Because it has that fallback, it can offer a lower rate than an unsecured personal loan might carry, say a few points lower. Suppose the sale brings $17,000 while you still owe $19,000, and the lender is $2,000 short and may pursue you for the difference, depending on local law; the same idea applies with a home securing a mortgage or savings pledged for a loan.

Easily confused

Collateral and its neighbours

Collateral is not a down payment, a deposit or a guarantee; a down payment is money you pay up front and is not returned. Collateral remains yours unless you default. A guarantor promises to pay if you do not, and that is a promise by a person, not a claim on an asset. Secured debt has collateral. Unsecured debt, such as most credit cards and personal loans, does not. Even so, an unsecured lender can take legal action to collect, and can sometimes get a judgment that reaches your assets.

In real decisions

Where collateral turns up

Collateral turns up whenever the amount is large or the borrower's history is thin. Mortgages, car loans, home equity loans and business equipment loans are all secured. Margin loans use investments as collateral. Pawn shops lend against goods. Business owners sometimes pledge inventory or receivables; borrowers use collateral to get better rates or larger amounts than they could get otherwise; lenders describe how much they will lend against it as a loan-to-value ratio.

Know the edges

Where collateral stops being reliable

Pledging an asset puts it at risk. A drop in its value can trigger demands for more collateral, as with margin loans. Insurance may be required, and there may be restrictions on selling it, and the lender's claim can outlast your intention to pay: missing a few payments can lead to loss of the asset; read what counts as default, how much notice you get and what happens to any surplus after a sale. Never pledge something you cannot afford to lose without understanding the terms.

Quick answers

What people ask about collateral

What happens to collateral when I pay off the loan? The lender releases its claim. For a car, you receive a clear title. For a home, the lien is removed and recorded. Keep the paperwork.

Can I sell an asset that is collateral? Usually only with the lender's consent, because it holds a claim. A sale typically pays the loan first. Selling without permission can breach the agreement.

Does collateral guarantee I will get the loan? No. Lenders also consider income, credit history and the size of the loan. Collateral improves the terms but does not replace those checks.