Consumer Credit: What Is Collateral?

Collateral is an item of value such as a car or a house, pledged as security for repayment of a loan.

Often times, the first time we borrow money, our first lenders are our parents. When parents decline to buy a wanted item, children often besiege parents with promises to pay them back from their allowance. Although you may not realize it, that is the first time you have offered collateral in exchange for a loan.

Collateral is an item of value that is pledged in exchange for a loan. This minimizes the lender's risk by ensuring there is an item of value to recoup his investment from in the event you stop paying on the loan. The less credit you have, the more likely it is a lender would demand collateral in exchange for payment.

When purchasing a home, the bank or lending institution places a lien on the property. The home is the collateral for the loan. If you stop making your mortgage payments, you lose the collateral promised to the bank, and they take your house and resell it. This is perhaps the most common example of how a person uses collateral to obtain loans.



Collateral is also referred to as a "security interest." Debt accrued on credit cards is often called unsecured debt since there is no recourse for the bank if you choose to stop making payments on the debt associated with the card. There is no collateral for the card issuer to seize in exchange for payment to minimize their losses. In some cases, such as furniture store purchases, any items purchased on the store account are subject to a security interest in the property. In this instance, the sofa, bedroom set or kitchen appliance is collateral. If you cease paying your bill, debt collectors may repossess the sofa, bedroom set or kitchen appliance until the debt is satisfied.

Cars can be used as collateral in many ways. The most common is to borrow the money for the car from a lender. This installment loan is divided into a set number of payments - most often 36, 48, 60 or even 72 months. The lender's assurance that you will make the payments is your car is their collateral. Even if you make 71 of 72 payments, the lender can repossess your car, sell it, and collect the balance owed.

A title loan can be obtained using a car that has not been pledged as collateral to another lender already. These loans typically carry very high interest rates, and are given to people with poor credit who need short term cash. Cars can also be pledged as collateral when borrowing money between friends and family.

The types of items used for collateral can change based on the situation. Cash can be a strong collateral in an investment fund. Bonds can have gold as collateral. When voting on measures, an incentive to vote for or against an item can be used as collateral.

Money and cars are not present in some culture and are not used as collateral. In parts of Africa and South America, the villages are so remote livestock may still be the primary form of collateral needed to pay for goods and services. Some would even argue the dowries in Indian cultures are collateral for promising to marry a daughter.

The applications of collateral are nearly as plentiful as the forms of collateral available. When promising an item for collateral, make certain the collateral promised makes sense for the size and type of the loan obtained. If you are lending money, it is important to verify the person promising the collateral owns it and that it is as valuable as the loan you are making.

© High Speed Ventures 2011