What Constitutes Collateral?  

Presented by: Marek Petynka

When one is seeking a loan, some form of collateral is often required.  The item(s) designated as collateral are used to “secure” the loan.  This collateral used in securing the loan can be taken by the loaning agency (usually your bank) in the event you default on the loan.  This reduces the loaning party’s risk, as people generally prefer not to have to default their most valuable pieces of property, and will thus make their required payments.  In the unfortunate event payments are not made appropriately, the lender can take the collateral property to offset his losses.

There are a variety of things one can use at the bank as a source of collateral.  Generally, smaller and specialty items (even if valuable) are not considered good sources of collateral by banks.  Instead, lenders would prefer items they believe they can re-sell if necessary to recoup for their losses in the event of a loan default. 

Four of the most common forms of collateral are as follows:

Homes

Homes are often used as collateral.  This underlying principle of a home’s mortgage is that the home is collateral against the amount of the loan.  So, virtually every homeowner has a secured loan in the form of his or her mortgage.  Additional loans using the home as collateral may be termed second or subsequent mortgages.  Homes make great collateral simply because their value is generally so much higher than the amount requested by the borrower, making loan approval relatively simple.

Automobiles

Cars are another popular means of securing loans.  Generally, a person’s car is their second largest investment after their home, so it would stand to reason that many people end up using the value in their car as a means of securing a smaller bank loan. Car loans are another example of a secured loan with collateral.  The car itself is security on the car loan.  If you miss your payments, the lender will be entitled to take possession of the car for purpose of eventual sale.  

Savings

Savings can also be used as collateral on a line.  Many people may find the idea of borrowing money at an interest rate higher than that paid on a savings account while using the savings themselves as collateral seems counter-intuitive.  It would be less expensive to simply take the savings than to accept the loan.  However, there are circumstances when this could make sense.  For instance, if you needed a long-term loan and wanted to retain the security of having some money in savings. 

Investments

Investments can also be used as collateral for loans.  Banks are willing to accept IRAs and 401K sums as collateral on personal loans.  The investments can be at least relatively valuable, creating a good level of payment security on a new loan. 

Banks require collateral when making loans in order to protect their own interests.  If it weren’t for collateral, banks would be remarkable stingy with their money and would charge a much higher interest rate for loans to compensate for their increased risk. 

If you should ever need a bank loan, you should be prepared to offer something as collateral on the loan.  The amount of collateral required, of course, will vary based upon the loan amount and the purpose for which the loan is targeted.  The amount and type of collateral required for the loan may also depend, based upon factors including one’s personal credit history and relationship with our bank.  

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