There are many terms and numbers in the world of lending. It can be both confusing and discouraging for newcomers to lending, who may not even know where to begin. It can be hard enough to admit that you need a loan – that you can’t afford what you need, even with your own income and credit – let alone having to decipher a language that seems completely foreign.
Despite this, trying to figure out the best way to get a loan doesn’t have to be complicated. While the terms may be confusing at first, as you progress, you’ll find that you understand more and more, and the shadow of mystery that can shroud the world of finances will slowly disappear.
One critical term you need to understand, that perhaps you’ve heard while you’ve explored your options for getting a loan, or just educating yourself about finances, is collateral. You may not know it yet, but collateral is a term that you absolutely need to understand, not only because of the possibilities it can open to you, but also the risks it carries.
What is Collateral?
In simple terms, collateral is something you own, that you commit as part of your loan agreement, that the lender can seize in the event that you fail to repay your loan. Collateral is an inherent factor in secured loans, and can help you in numerous ways, while presenting some potential risks that you’ll need to be aware of.
What Are Some Examples of Collateral?
As I mentioned above, collateral constitutes any kind of asset(s) that can match the value of your loan, and can vary widely, based on what the lender is willing to accept. In some cases, the end item the loan is being used to purchase will serve as the collateral, which is the case in mortgages: if you default on the loan, the lender will take your house. Other examples of collateral can include:
- A Car
- Stock Investments
- Profits (for business startups)
What the lender is willing to accept as collateral, and how much, will be determined by the amount you’re trying to borrow, and what the loan will be used for.
For example: if you’re trying to borrow $100,000 to renovate your house, the lender will probably not be willing to accept your jewelry as collateral, as it would most likely require many different pieces to total up to 100K. By contrast, if you promised your car, valued at $60,000 as collateral, the lender would be much more willing to work with you.
How Can Collateral Help Me?
Collateral can be useful when you’re shopping for loans, because it gives you some additional negotiating power with lenders. You may have an excellent credit score, but if you only make around $30,000 a year, and you’re trying to borrow $300,000 to start your own business, many lenders would be hesitant to work with you. That’s a lot of money, and if you’re only making $30,000, the threat of you defaulting is high, and it’s going to take a long time to pay it back in full.
However, if you were to include your home, valued at $300,000, as collateral, a lender may be much more willing to work with you because, regardless of whether or not you default, the lender is all but guaranteed to get their investment back. This example assumes that your credit score is high to begin with, but collateral can be every bit as effective if your credit is low. Indeed, it can be even more useful.
When it comes to loans, a poor or fair credit score will usually yield a lower amount you can borrow, and substantially higher interest rates. If your credit score is low, even because of events that weren’t completely your fault, a lender will regard you as less trustworthy based on your score. This creates more risk for them, with any kind of loan they might extend to you.
Collateral can help you offset the negative association that a poor credit score will create. Because collateral has an assessed value, it’s concrete – the lender knows that they will get back at least the amount that the collateral is worth. In turn, collateral can allow you to enjoy a higher limit on your loan, as well as a reduced interest rate.
What are the Risks with Collateral?
By its inherent nature, a secured loan is going to place more risk on the borrower, because you stand to lose much more than the lender, if you default on the loan. The first, and most obvious risk, is that you’ll lose whatever asset or assets you’ve pledged as collateral.
Losing your collateral is bad enough, in and of itself, but it can also create some ripple effects that will make your circumstances even more dire. If you’ve pledged your car or home, you’ll lose these assets, and you’ll have to find someway to replace them. With a default loan on your credit history, you’re going to have a much harder time finding a lender who’s willing to work with you to take out a mortgage or car loan.
In addition to a negative item on your record, your credit score is going to take a severe hit, if you default on a loan. Because your financial history, or how many times in your life you’ve been late on a payment, missed a payment, or defaulted on a loan, carries 35% of your total credit score, this will be extremely difficult to recover from. Not only that, but your lowered credit score will create even stricter loan limits, and higher interest rates, in the future, and you now have one less thing you can use as collateral to offset your poor credit score.
Should I Use Collateral?
That depends entirely on you. We’ve discussed that collateral can be very useful, but it also carries great risk. Most of the time, a secured loan creates an excessive amount of risk, that I would only recommend in extreme circumstances. If you’re in danger of losing your home, and you’re willing to sacrifice your car as collateral, in order to keep a roof over your head, I completely understand that. But in most cases, using an unsecured loan is a much safer option.