Collateral is an asset one can use to secure a loan. When you go borrowing, you agree that your lender can hold something and trade it to repay their cash if you fail to pay back. It is through collateral that you can get huge loans, and better your chances of approval if getting a loan is proving difficult.

Anytime you put some collateral on the line your lender reduces liability meaning you’re likely to enjoy better rates.

How Does Collateral Work?

Most times collateral is required when a lender needs assurance that in the worst case scenario, they won’t lose all their funds. The implication is that if you pledge an asset as collateral, the lender can legally take action in the event you stop repaying the loan. They can seize the collateral, trade it, and use the amount they earn from it to pay off your loan.

To put it briefly, lenders want to be sure they’ll get their money back, so they use collateral as security.

Types of Collateral

You can use any legal asset that a lender agrees to hold can as collateral.

But most times lenders prefer taking assets they easily value and sell. Common types of assets to use as collateral include:

  • Automobiles
  • Real estate
  • Cash accounts (but retirement accounts have restrictions)
  • Machinery & equipment
  • Investments
  • Insurance policies
  • Valuables & collectibles
  • Future payments from buyers (receivables)

Note that for a business loan, you can pledge some personal assets (maybe a family home) as a personal guarantee.

Also, be aware that most lenders often turn down those who try using their retirement accounts like IRAs as collateral.

How to Value your Asset

Typically, lenders offer an amount less than the value of the asset you pledge. Some assets might be heavily discounted. For instance, a lender may choose to take only 50% of your investment portfolio for use as collateral. By doing so, they boost their chances of getting back all their money in the event investments lose their value.

During loan applications, lenders quote a tolerable LTV (loan to value ratio). A lender may put the LTV at 70%, so if you pledge an asset that’s worth $100,000, they allow you to borrow a max of $80,000.

Collateral based Loans

Collateral based loan products are common among lenders. You can use collateral to acquire both business & personal loans. Most startups that have no track-record of generating steady profits are asked to pledge collateral.

In rare cases, you get the loan, buy an asset, and then pledge it immediately; just like a lender would work with an insurer (for life insurance cases) to provide the policy & collateral loan at a go.

The same applies for a mortgage; the home serves as collateral, and the lender has the right to foreclose if you default repayment.

There are also collateralized loans for those with bad credit. However, these loans are expensive and should be your last resort. Plus, they should be handled with caution; failure to repay may lead to serious consequences; like the lender may take back the vehicle and sell it.

Conclusion

Always be sure to double-check the terms & conditions of the collateral loan you go seeking to ensure you know what you’re committing to.

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