What are loan collateral?

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Loan collateral identifies a borrower-owned asset of value, either physical or non-physical, that is used by a lender as security for a loan. Loan collateral is a key ingredient with secured loans and financing programs.

By requiring collateral or security for the loan, the lender forces the borrower to put skin in the game. If the borrower defaults, the lender may be able to use the collateral to pay off the remaining loan balance.

Reason for collateral requirement

All loans involve risk, particularly for the lender. Banks, credit unions and financing companies understand that they face risks with all the loans they issue to borrowers.

The challenge for lenders is to keep their risk exposure at a manageable level. To keep their risk exposure at an acceptable level, lending institutions rely on underwriting guidelines and lending criteria to limit which loans they will and won’t issue. These criteria may include the following:

  • Credit history and FICO scores – provides an indication of the borrower’s past debt- and credit-management habits.
  • Debt-to-income levels – measures how much the borrower has available to make projected monthly payments
  • Employment history and stability signals potential income instability that may arise in the future
  • Minimum reserve cash requirements – ensures that the borrower will not be living paycheck to paycheck
  • Identity verification – prevents potential fraud, which can harm both the lender and the person whose identity is being misused
  • Loan collateral – provides security that can be used to lower the lender’s losses, as well as give the borrower an additional incentive to meet debt obligations.

Depending on the loan program, the lender may take actual (physical) possession of the loan collateral during the life of the loan. With some programs, the borrower keeps possession of the loan collateral but pledges it to the lender, often with a recorded lien.

Types of loan collateral

Different loan and financing programs require different types of collateral. Here are some of the most common types of loan collateral used with consumer loans today:

  • Car loans. One of the most common loan types involving collateral are automobile loans. When a consumer uses a car loan to purchase a vehicle, the lender will typically receive the legal title to the car. The borrower will still keep possession of the vehicle, but the lender will keep the title until the loan is paid off. If the borrower defaults on the car loan, the lender’s title will allow it to repossess the vehicle.
  • Mortgage loan. Another common type of secured loan is the real estate or mortgage loan. However, depending on the state in which the property is located, the mortgage loan is secured in one of two ways. With a standard mortgage loan, the mortgage lender places a lien against the property. If the borrower defaults, the lender must pursue foreclosure proceedings to have the property sold, so as to pay off the mortgage lien. With a mortgage deed of trust, the property’s title is actually put into a trust. If the borrower defaults, the lender can direct the trustee to sell the property, so as to pay off the loan. In either case, if the property cannot be sold for a high enough amount, the lender can step in and take ownership of the property.
  • Pawn loans. One of the oldest form of secured personal loans are pawn loans, which provides the borrower with loan funds in exchange for “pawning” some personal property owned by the borrower. If the borrower repays the loan, the pawn lender will return the collateral property back to the borrower. If the borrower defaults, the pawn shop can sell the property to recoup its loan funds.
  • Title loans. Also called pink slip loans and title pawn, automobile title loans are similar to standard car loans in structure. However, instead of helping a person purchase a vehicle, an auto title loan helps car owners pull cash out of vehicles they currently own in full. As with standard car loans, the title loan borrower gives the car’s title to the title lender until the loan is paid off.
  • Secured credit cards. Another form of secured debt is the secured credit card, which requires the borrower to make security deposit to obtain a credit line. In most cases, the credit line is equal to the security deposit. If the credit line is cancelled and the balance is fully paid, the security deposit is returned to the borrower. However, if the borrower defaults on the credit line, the creditor will use the security deposit to pay the remaining balance and applicable fees.

Loan collateral has been a key element with all types of loans for millennia. However, when it comes to personal loans, there are sometimes unsecured loan options that require no loan collateral. Consumers should always review their options, do their due diligence and consult with a financial advisor before entering into any loan agreement that requires loan collateral.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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