What are collateral assets?

ByMunyaradzi Mafaro

Collateral assets are things of value that someone borrows money against. They help make sure the person lending the money will get paid back. Common types of collateral assets include:

  • Cash
  • Stocks and bonds (called securities)
  • Money owed to a business by its customers (called accounts receivable)
  • Products a business has to sell (called inventory)
  • Letters saying a bank promises to pay (called letters of credit)
  • Physical property like real estate, vehicles, or equipment

How collateral assets work

When you borrow money from a bank or other lender, they take a risk trusting you’ll pay them back. This is called credit risk. To lower their risk, lenders often ask for collateral assets.

You give the lender the right to take your collateral assets if you don’t pay back the loan as agreed. This gives the lender another way to get their money back if you can’t make your payments. The lender feels safer lending you money when you put up collateral.

The lender’s rights to the collateral

The lender puts a lien on your collateral assets when you borrow money. A lien is a legal right to take property if a debt isn’t paid. The lien gives the lender an ownership stake in your assets until you fully repay the loan. You get to keep and use the assets while you’re paying off the loan. But if you default, the lender can seize them.

For example, say you take out a car loan. The car is collateral for the loan. You drive the car while you make your monthly payments. If you stop paying, the lender can repossess the car to help pay off your debt.

Types of loans that use collateral

Many types of loans are secured by collateral assets. Here are some of the most common.

Mortgages

When you get a mortgage to buy real estate, the property is collateral for the loan. If you don’t make your mortgage payments, the lender can foreclose. This means they take ownership of the property and evict you. They sell the property to get back the money they lent you.

Home equity loans and lines of credit

If you already own a home, you can borrow against your equity. Equity is the part of your home’s value that you own outright. These loans use your home as collateral too. You can lose your home if you don’t repay as agreed.

Auto loans

Auto loans are secured by the vehicle you’re buying. If you default on your payments, the lender can repossess the car. They’ll sell it and use the money to pay off your loan balance. If the car sells for less than what you owe, you have to pay the difference.

Secured personal loans

Some personal loans are also secured by collateral. You might put up assets like cash in a savings account, stocks and bonds, or valuable items like coin collections or jewelry. If you default, the lender can take your assets. Unsecured personal loans don’t involve collateral.

Business loans

Business loans are often backed by company assets. Accounts receivable, inventory, equipment, or real estate can serve as collateral. If the business fails to repay, the lender can seize and liquidate these assets. Owners also pledge personal assets in some cases.

Secured credit cards

Secured credit cards require you to put down a cash deposit as collateral. Your credit limit equals your deposit amount, typically $200 to $2,000. If you don’t pay your credit card bill, the card issuer keeps your deposit.

Pros and cons of collateralized loans

Putting up collateral assets has benefits and drawbacks. Here’s what to consider.

Advantages of using collateral

  • Easier to qualify. Assets help you get approved even with shaky credit or income.
  • Lower interest rates. The lender takes on less risk, so they charge less interest.
  • Higher borrowing limits. You may access more funds than with an unsecured loan.
  • Build credit. Making payments as agreed improves your credit scores over time.

Disadvantages of using collateral

  • Risk of losing assets. The lender can take your property if you default. You could lose your home or car.
  • Longer application process. The lender must verify and value your assets, which takes time.
  • Reduced access to assets. You may not be able to sell or refinance assets until you repay the loan.
  • Required maintenance. The lender may require you to maintain or insure assets used as collateral.

What lenders look for in collateral assets

Not all assets qualify as collateral. Lenders evaluate assets based on certain criteria.

Value

An asset must be valuable enough to cover potential losses if you default. The lender looks at the asset’s fair market value. This is the price it would sell for in current market conditions. If you stop paying, the lender must be able to sell your asset for enough money to recoup their loss. They typically lend a percentage of the asset’s value, such as 80% for home mortgages.

Liquidity

Liquidity measures how quickly and easily an asset converts to cash. The more liquid an asset, the more readily a lender accepts it as collateral. Cash is the most liquid asset, followed by securities traded on an exchange. Real estate and equipment are less liquid. They take more time and effort to sell.

Stability

Lenders prefer collateral that holds its value or appreciates over time. If your asset declines in value, it may no longer fully secure your loan. Some lenders require you to put up more assets if this happens. Real estate historically goes up in value, making it attractive collateral. Vehicles quickly depreciate and are riskier.

Ownership

To pledge an asset as collateral, you must own it outright. It can’t already be used to secure another loan. The lender checks for any claims, liens, or restrictions against the property. They may require a clear title or proof of authenticity. You can’t borrow against leased or rented items.

Control

Lenders must be able to take control of collateral assets if you default. They prefer assets they can easily locate, identify, and sell. Cash and financial securities are effective because the lender holds them. With physical assets, the lender must be able to find them. Some property, like jewelry or art, is harder to value and sell quickly. Lenders may not accept it or give it a lower value as collateral.

Risks of using collateral assets for loans

Pledging collateral assets poses risks. The lender can seize your assets if you default on the loan. You could lose your:

  • Home through foreclosure
  • Vehicle through repossession
  • Savings or investments held as collateral
  • Valuables like jewelry, antiques, or collectibles
  • Business property, equipment, or inventory

This could leave you in a tough financial spot, especially if you rely on the asset. Losing a vehicle could mean having no way to get to work, for example.

Seizing assets also hurts your credit. It stays on your credit report for 7 years. This makes it harder to get approved for loans and other credit in the future.

Think about the worst-case scenario before borrowing against assets. Make sure you can afford the payments. Have a plan to cope if the lender takes your assets.

Munyaradzi Mafaro is a music enthusiast and he also likes to tackle topics of business, productivity, and the possibilities for growth in the digital world.