Collateral can be any of your valuable assets that can be used as a security against a loan.
Certain types of assets such as personal clothes, household appliances, electric items, future earnings, social security benefits, retirement funds, intangible assets, assets with existing loans, and illegal items cannot be used as collateral.
In short, collateral should be any of your legitimate assets having economic value that a borrower can take into possession upon default.
So, to pledge an asset as collateral, a borrower needs to prove his ownership and ensure future transferability, and economic value.
Most importantly, any asset to be pledged as collateral needs to be converted into cash easily without any risk of value dilution or ownership transferability problems.
Key Takeaways
- Collateral secures your loan by reducing the risk of the lender
- Loans secured with collateral offer lower interest rates than unsecured loans
- An asset needs to be legally owned by an owner with future economic value and transferability to be pledged as security
- Illegal items or items having future uncertainty cannot be used as collateral
How does collateral work?
Collateralizing a loan represents securing the borrowed amount by pledging any of the owner’s valuable assets so that the borrower can encash the outstanding debt by taking the pledged asset in its possession.
Collateral reduces the risk of a lender in case of default. This is the reason secured loans usually have lower interest rates compared to unsecured borrowings.
Collateral is only required for a secured loan since the unsecured loan does not need any security.
Let me give you an example.
Let’s say, you are going to take a term loan of $10,000 with 5% interest for 5 years. Your lender may ask for a security, typically any of your assets for the loan amount.
Your lender may ask for security. The lender wants you to confirm to transfer of the ownership and custody of that pledge’s asset in case you are not able to repay the loan.
In such cases, assets like cars, homes, land, or company shares can be used to secure the loan.
Often, credit card companies ask for a cash security deposit for new customers having less banking history or poor credit scores.
Remember, the lender does not take the possession of borrower’s asset immediately. In case of any missed or late payment, there should be legal steps such as penal interest or appointing a collection agent.
Banks or lenders will only take borrower’s pledged assets in case of official default.
How does collateral vary by loan type?
Borrowers use collateral to secure the loan. Any asset with economic value becomes collateral. However, the nature of the security or pledged asset may vary depending on your loan type.
For example, if you take a mortgage or home loan, your house becomes the collateral. Or, if you buy a car with a car loan, the car becomes the pledged asset for that particular loan due to its inherent nature.
There are some loans such as Payday loans or Peer to Peer loans can require confirmation of your future earnings as a security but for the banks, future earnings cannot be used as a security.
Unless the loan specifies the purpose (car loan, home loan), any other loans would require a security, and your lender would decide if it going to classify your asset as a pledges security against the borrowed amount.
When an asset can be used as collateral?
To pledge an asset, borrowers need to prove the ownership of the asset and ensure future economic value, plus an assurance of future transferability.
The first requirement is the legal ownership. Borrower cannot pledge any asset that is owned by someone else or jointly owned. (joint assets can be used as security in case of a joint loan).
Secondly, the asset needs to have an identifiable future economic value. Lenders may seek a valuation certificate or insurance coverage before accepting your pledged asset.
Furthermore, Collateralized asset needs to be legally transferable and encashable in future. A borrower cannot pledge any non-transferable asset. Such as a PhD degree or any award cannot be used as a security against the loan.
Lastly, any asset already used as collateral (first lien) cannot be used again as collateral (second lien). However, a second lien can be acceptable if both lenders agree to use the asset and double the lien. But, in case of default, the first lender (first lien) gets priority.
There is a Latin phrase ‘Pari-Passu’ – meaning ‘equal footing’ is as example of pledging an asset twice to two lenders. Usually, companies can use Pari-Passu to pledge any of their valuable assets such as land or buildings to multiple lenders. If any asset is recognized as a Pari-Passu, it represents equal rights for both of parties in case of default.
Businesses can also use their inventory (stocks) as collateral usually for the shorter working capital loans. Stocks can only be used as a security for revolving working capital loans such as Cash Credit Hypothecation or, CC Hypo.
Banks accept inventory as a security with the hope that the business always maintains sufficient stocks for the customers. However, for such cases, the borrower needs to send a monthly inventory report to the lender as a part of accountability.
You would also see that banks usually ask for an undated cheque for personal loans. Such cheques are not collateral. Lenders usually take such cheques or payment instructions just to make the borrowers obliged in the future. I have seen earlier that, banks sue the borrower for cheque dishonor in case of default.
Which assets cannot be collateralized?
The following assets cannot be pledged as collateral.
Personal Items: Clothes, personal electronics, and everyday household goods generally cannot be used as collateral.
Future Earnings: Potential future income or earnings cannot be pledged as collateral.
Public Benefits: Social Security benefits, unemployment benefits, and other forms of public assistance cannot be used as collateral.
Retirement Accounts: Most retirement accounts, such as 401(k) plans, IRAs, and other pension plans, are generally protected from being used as collateral due to legal protections.
Intangible Assets: Assets like patents, trademarks, copyrights, and other intellectual property might be difficult to use as collateral because they are intangible and their value can be hard to determine.
Assets Owned by Others: You cannot use property or assets owned by someone else as collateral unless you have their explicit permission.
Assets with Existing Liens: If an asset already has a lien against it from another loan, it generally cannot be used as collateral for a new loan.
Illegal Items: Any asset that is illegal or obtained through illegal means cannot be used as collateral.
Which loan does not require any collateral?
Unsecured loans do not require any security against the borrowed amount. Usually, unsecured loans are comparably smaller than secured loan and issued to persons having a prior loan history and decent credit score.
For example, if you are maintaining your payroll account with any bank, you can easily get a credit card (an unsecured loan) without any collateral.
Or, if you borrow from any Peer-to-Peer platform, it depends on the lender whether he needs any guarantee or not.
Pros and cons of pledging assets as collateral
Pledging assets as collateral would have the following positive side:
- Lenders typically offer lower interest rates for secured loans because they carry less risk due to the collateral.
- Because the collateral reduces the lender’s risk, the borrower may qualify for a larger loan.
- Pledging an asset makes the loan approval process faster because it requires supporting documents to justify the property value.
- Secured loans often come with more flexible and longer repayment terms.
- Pledging collateral can sometimes provide access to better overall loan terms, such as lower fees or more favorable repayment schedules.
Following the negative sides of collateral:
- Risk of losing assets in case of default.
- Some assets would cost you for valuation which is time-consuming as well.
- Collateral evaluation and legal formalities sometimes slow down the loan approval process.
- Not all assets can be used as collateral.
Final thought
Collateral reduces the lender’s risk exposure by securing borrowers’ debt liability. Pledging as an asset can be a good strategy for the borrower to get low interest rates and flexible loan terms. However, risk of losing the asset would always be there along with other pros and cons.
