What is collateral and how does it work in the mortgage loan process?
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If you’re buying a home with a mortgage or refinancing, the mortgage lender needs to be confident you’re going to be able to repay the funds. A strong credit score and a history of smart financial decisions can provide some degree of assurance, but a lender also relies on the collateral that secures the loan — the home — to make the approve-or-deny decision.
What is collateral?
Collateral refers to an asset that a borrower offers as a guarantee for a loan, such as a mortgage. When you obtain the loan, the lender puts a lien on the collateral. The lien stipulates that the lender can seize the collateral if you don’t repay the loan under the terms of the contract. Once you repay the loan, the lender removes the lien and no longer has a claim to the collateral.
No matter what you use as collateral or what you want to do with the money you borrow, the definition remains the same: It’s your offering to help secure a loan.
How does collateral work?
Collateral applies to all kinds of secured loans, not just mortgages. (There are also unsecured loans that don’t require it.) For example, if you’ve paid off your car in full and the title is in your name, you can use that asset as collateral to borrow money for another expense. In this case, a lender can reasonably expect that you’ll pay the money back. If you don’t, the lender is legally able to take your car.
Collateral doesn’t necessarily have to be property, either. Some lenders let borrowers use their savings account as collateral. For instance, if you have $3,000 in your bank account or a CD, you might be able to use that as collateral to borrow more money. If you don’t repay the money you borrowed, the lender can take your cash in that account instead.
There are rules around how a lender can recoup losses, however, depending on whether the loan is a recourse or non-recourse loan.
- Recourse loan: With a recourse loan, the lender is legally permitted to pursue other assets or sue the borrower to garnish wages. So, if you don’t pay the loan back, you could lose your collateral along with future paychecks and other valuable property.
- Non-recourse loan: With a non-recourse loan, the lender has to absorb any difference between the value of the asset they seize and the balance on the loan. You still lose your collateral, but you don’t run the risk of losing other property or money.
How collateral works in the mortgage loan process
In the case of a mortgage, the collateral is the home, also referred to as “real property.”
When determining whether to approve your loan, the lender will order an appraisal of the home to ensure that the property — the collateral — is actually worth what you propose to pay for it with the loan. If it isn’t, the lender can deny the mortgage because the asset isn’t worth the risk.
On the other side of things, if you don’t repay the mortgage and can’t come to a relief agreement with your lender, the lender can foreclose on the home, and you’ll lose that collateral.
Examples of collateral in the mortgage process
- Buying a home: When you buy a home with a mortgage, the home will serve as collateral for the loan. If you miss a certain number of loan payments — typically three to six months in a row, but as soon as one missed payment — you’ll be considered in default on the loan. Avoid this scenario at all costs, as that’s when the lender can foreclose and take back the collateral (your home).
- A home equity line of credit (HELOC) or home equity loan: You can use the equity you have in your home as collateral for a HELOC or a home equity loan, which can help pay for other expenses. While there are some differences between a HELOC and a home equity loan, the key similarity is that you’re putting your home on the line as collateral.
- Starting your own business: If you’re looking to launch a small business, you might be able to use your home as collateral to secure a small business loan to help lay the groundwork for your new venture.
The concept of collateral might sound a bit daunting — no one wants to entertain the possibility of losing something of value, particularly if it’s the roof over your head. However, collateral plays a key role in helping you secure the money you need to buy that roof. Whether getting a mortgage or any other type of secured loan, when a lender asks for collateral, make sure you have the means to pay the loan back. Otherwise, that collateral could wind up in the lender’s hands, and you’ll lose that asset.