Loans are divided into two groups: secured and unsecured. You qualify for a secured loan through collateral, while qualifying for an unsecured loan involves your credit score and financial history.

What exactly does collateral mean in the context of lending, and how does it operate? 

What is Collateral?

The term collateral refers to the assets committed by a borrower to a creditor as security for a loan.

Collateral can be real estate, shares of a company, a savings account, or another item of value. These assets act as a form of security for the lender. In other words, if the client defaults on a loan, the creditor may seize the collateral to recoup all or part of its loss.

Types of Collateral 

The type of collateral is often predetermined by the loan type — a mortgage is collateralized by the home, and a car loan is collateralized by the car. But there are some collateralized loans that can accept a variety of collateral. 

For personal loans or business loans, collateral can include a fully-owned car, bank savings deposits, investment accounts, or business inventory. Some lenders will allow for future paychecks to be used as collateral for short-term loans, but these loans often have less attractive terms than other collateralized loans. 

Types of Collateralized Loans 

Mortgage

A mortgage loan is amongst the most widely used types of secured loans. The real estate you are funding serves as collateral for secured loans. When a loan defaults due to missed repayments, the creditor may foreclose on the borrower’s home and sell it to collect its losses.

Home equity loan

A home equity loan is backed by the equity in the property, which is the gap between the home’s current value and the mortgage balance. You can borrow money using your equity with a HEL, commonly referred to as a “second mortgage.”

Car Loan

As the name suggests, this loan is secured by a vehicle. This takes place if you use a loan to finance acquiring a car, tractor, motorbike, or even a private plane. Like a mortgage, the vehicle may be reclaimed if the loan is not repaid.

Secured Personal Loans

Personal loans can be used for various needs. Financial institutions offer both secured and unsecured personal loans.

Putting up collateral for a secured personal loan will likely result in better conditions and interest rates. Theoretically, any asset of value can be used as collateral if the lender agrees to the terms. Common forms of collateral include real estate holdings, cash, investment accounts, savings accounts, paid-off vehicles, and fine art or jewelry.

How Does Collateral Work? 

Lenders would like to be sure that you have the means to pay back any loans before they give them to you. Because of this, they will need security of some kind to ensure the lender fulfills their financial commitment.

If the borrower fails to repay the loan, the lender has the power to possess the collateral and use the proceeds to cover the outstanding balance. To recover any outstanding balance, the lender may decide to pursue legal action.

Collateral-backed loans typically have interest rates that are lower than those of unsecured loans. When a borrower records a claim over an asset — either a fixed or variable charge — it forms collateral security. These charges are also referred to as liens. Since they risk losing their properties and perhaps other assets used as collateral if they don’t make their payments on time, the debtor has a strong incentive to pay back the loan.

How is Collateral Valued?

Collateral “value” can be seen in two separate forms. While market factors influence both, one is its relative desirability, and the second is its monetary value.

The Asset’s Level of “Desirability”

The Marketable, Ascertainable, Stable, and Transferable (MAST) approach is a helpful tool for conceptualizing the entire desirability of collateral.

An active secondary market for the property is implied if the asset is marketable. Excellent examples include equities and bonds, which are traded on international marketplaces. On the other hand, some assets are less marketable and only attract a specific audience. 

The A of MAST refers to how simple it is to estimate or quantify a market value. For assets such as stocks, bonds, or cash, the value of the assets is easily ascertained due to frequent trading on the public markets. For other assets that are not publicly traded, the market value may be determined with the help of an appraiser. 

How steady is the value of the asset? Stocks, in general, can sometimes be unpredictable, leaving the collateral’s current value potentially highly variable. Marketable assets have an active secondary market and whose valuations are marked-to-market. But from the other end, commercial real estate is usually considerably more consistent.

The asset may be transferred. The costs involved with transferring this collateral might be very significant. For example, a forestry company might want to commit inventory as collateral. Some of that inventory could be situated in a distant area that is challenging for 3rd parties to access. Unlike real estate, a collateral mortgage arrangement on the subject property must be discharged (and re-registered).

Monetary Value of the Asset 

Loan-to-value Ratio (LTV) 

LTV refers to the ratio of the loan amount to the appraised value of the underlying collateral. A loan with a low LTV ratio indicates a greater probability that the proceeds of the sale of the collateral would cover the loan amount in the event of non-payment. 

Debt Service Coverage Ratio (DSCR)

DSCR is the ratio that measures the cash flow available to service debt – or pay back debt. The DSCR is calculated by dividing an individual or business’s net income by its outstanding debt obligations. A higher DSCR indicates higher creditworthiness of a borrower, meaning the borrower is more likely to have the ability to repay its loan. 

The Bottom Line

For lenders to lower their risk, collateral is essential. A lender may opt to seize possession of the collateral promised to them in the agreements you signed when you applied for the loan if you cannot repay the debt. Normally, if you miss one or two interest payments, a bank won’t seize ownership of the collateral; however, if they believe their loan is in jeopardy, they will.

Not only do collateralized loans often provide more attractive terms for a borrower, they also can put the value of your assets to work by providing cash for non-cash assets. For example, a classic car collector could use a vintage car as collateral for a loan, allowing them to borrow cash that could potentially be used for profit-making. 

Collateralized loans also are generally easier to obtain for borrowers with weaker credit. If the loans are paid off in time, collateralized loans will also help a borrower build a strong credit profile, making more attractive loan terms more accessible to borrowers in the future. 

This content is provided for informational and educational purposes only.  It is not intended to be investment advice nor should it be relied upon to form the basis of an investment decision.