What is collateral? Definition, examples and more

If you compare different types of loans, you might notice that some may require collateral. But what exactly is collateral? And why don’t all types of financing require it?

What you’ll learn:

• Collateral is an asset, such as cash or property, that can help borrowers qualify for a loan by lowering the risk to a lender. 

• Secured loans require collateral but unsecured loans don’t.

• Auto loans, mortgages and secured credit cards are examples of secured loans.

• Collateral may increase chances of approval, but defaulting on a loan puts the collateral at risk.

In lending, collateral is an asset that a borrower uses to secure a loan. Collateral can take the form of a physical asset, such as a car or home. Or it could be a financial asset, like investments or cash. 

Lenders may require collateral for certain loans to minimize their risk. Examples may include when a lender is financing a home loan or car loan or extending a line of credit.

Collateral reduces lending risk, because it can help offset the losses if the borrower defaults on a loan. 

The process can be complicated. But in general, a lender might put a lien on collateral, which gives them the right to seize it and sell it to recoup unpaid debt.

Collateral can take many forms. It often depends on the type of loan. For example, when a mortgage lender issues a home loan, the house generally serves as the collateral until the loan is paid off.

Other types of collateral may include:

1. Real estate
2. Vehicles
3. Cash
4. Investments
5. Insurance policies
6. Equipment and machinery
7. Valuables and collectibles, such as artwork

No. To understand how collateral is used, it may help to remember that there are two basic types of loans: secured and unsecured. 

A loan that requires collateral is known as a secured loan, because the collateral serves as security for the lender in the event of a default. Unsecured loans don’t require collateral.

Common secured loans include:

The vehicle generally serves as the collateral. If you fail to repay the loan, the lender may repossess the vehicle to recoup some of the loan amount.

A home or property typically serves as collateral. Should you default on the mortgage, the lender may be able to foreclose on the home or property.

HELOCs also use a borrower’s home as collateral. HELOCs are an example of revolving credit that might allow you to draw from a line of credit, repay it and then draw from it again when you need more funds.

Home equity loans also typically use a home as collateral. Unlike a HELOC, loans are typically provided as a lump sum to pay back over a fixed term.

Collateral for a secured personal loan could include savings accounts, certificates of deposit (CDs for short), stocks, bonds or property. Just like other types of secured loans, you risk losing the collateral if you can’t repay the loan.

Secured credit cards typically require a security deposit used as collateral to open the account. If you have new or poor credit, it might be easier to qualify for a secured credit card than a traditional unsecured card. And with responsible use, a secured card can help you build credit.

Business loans, which can be used for things like buying equipment or funding company projects, are another type of loan that may require collateral. In this case, collateral may include assets like inventory or land.

Depending on your situation, there could be advantages and disadvantages to getting a secured loan. Here are some to consider:

Some advantages of loans with collateral may include:

• Higher approval odds: When approving a loan, lenders typically review your credit history to determine their credit risk. If you can provide collateral, it could help you get the loan—even if your credit needs improvement or you’re still establishing credit.

• Lower interest rates: Secured loans can sometimes have lower interest rates than unsecured loans. That’s because the lender may be able to take possession of the asset to recoup their losses if you default on the loan.

• Potential for higher loan amounts: Depending on the lender, you can sometimes secure larger loans when using collateral as backing. The value of the asset may also factor into the total loan amount.

Disadvantages of loans with collateral may include:

• Risk of losing the collateral: If you default on a secured loan, the lender can repossess the asset to help make back their lost revenue. 

• Longer approval process: When using collateral to secure a loan, qualification may take longer than it does for an unsecured loan.

• Potential impact on credit scores: Repossessions and other derogatory marks have the potential to negatively affect your credit scores for up to seven years, which can make it harder to qualify for other types of loans or lines of credit with better loan terms in the future.

It’s important to understand how collateral works before you apply for a secured loan. One major reason: When you use collateral as a form of security, a lender could take possession of it if you default on the loan. 

While you’re thinking about loans, it may help to review your credit scores and credit reports to better understand your financial standing. That’s where CreditWise from Capital One can help. It’s free, and using it won’t hurt your credit scores.