Knowing about collateral can help you with taking out a loan. Bankrate explains.

What is collateral?

Collateral describes the personal property or assets that a borrower offers to a lender to secure a loan. As part of the loan agreement, the borrower forfeits the asset to the lender if she stops making payments on the loan. The lender’s claim to the collateral used for a loan is called a lien. Lenders refer to collateral loans as secured loans because the asset secures the funding.

Deeper definition

By asking for collateral, lenders absorb less risk, which is why secured loans are often one of the only options for borrowers with poor credit. In many cases, the type of collateral used is directly related to the type of loan a borrower takes out. For example, in a mortgage loan, the collateral may be the home that the borrower is buying or borrowing against to secure the loan. Other types of collateral include automobiles, bonds, equipment such as computers or lawn mowers, or gold.

Although the borrower risks forfeiting his property or business assets to the lender, putting up collateral can lead to higher borrowing limits and lower interest rates. However, depending on the type of collateral loan, a lender can take the borrower’s property, sell it to pay off his debt and still come after him for any balance left on the loan.

Collateral loans come in two different forms that differ on the lender’s rights to satisfying the borrower’s debt:

  • Recourse loan: The lender is legally permitted to pursue other assets or sue the borrower to garnish his wages.
  • Non-recourse loan: The lender has to absorb any difference between the value of the asset they seize and the balance on the loan.

Bankrate offers a number of solutions to get out of debt.

Collateral example

Sheila takes out a recourse mortgage using her home as collateral. Sheila has a mortgage that she pays faithfully for five years, but when she loses her job she becomes unable to continue meeting her monthly payments. Her mortgage goes into foreclosure and the lender seizes the house. At the time of foreclosure, Sheila still owes $200,000 on her mortgage. The lender sells the home for $180,000, leaving a balance of $20,000, which the lender sues her for. The lender garnishes her wages until the balance is paid.

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