What Is Collateral and Why Is It Important

The fundamental difference between a secured and unsecured loan is the collateral requirement. But what is collateral? Why is it important? And what is a lien? Here’s everything you need to know:

What is collateral?

Collateral is an asset you are willing to pledge to a lender to secure credit. The asset is often physical, such as real estate or equipment, and its purpose is to protect the lender. If you default on your loan payments, the lender can seize and sell the collateral to recoup their losses.

“Loans that use tangible assets as collateral are called secured loans,” writes finance expert Susan Ward. “The advantage of secured loans is that they often have lower interest rates than unsecured loans.”

In short, collateral allows you to get a better loan by shouldering the risk associated with being unable to make your payments. 

What is a lien?

A lien is the lender’s claim to the collateral used for a loan. In other words, it’s the legal mechanism that enables lenders to keep possession of your assets until your debt has been cleared. This is important to know because while some loans do not require physical collateral, they may take a lien on your business’s assets.

Types of collateral

There are many different types of collateral. According to Investopedia’s Julia Kagan, “The nature of the collateral is often predetermined by the loan type. When you take out a mortgage, your home becomes the collateral,” she explains. “If you take out a car, then the car is the collateral for the loan.”

However, you can still put up assets as collateral for loans that have nothing to do with the asset itself. For example, cars — if paid off in full — are commonly accepted as collateral for other loans. Lenders may also accept investment accounts and savings account deposits as collateral, but not retirement accounts. You can even use future paychecks as collateral for very short-term loans, though it’s only recommended to do this in genuine emergencies.

Valuing collateral

Before an asset can be put up as collateral, it needs to be valued. Lenders usually conduct an assessment and appraisal review process to determine the market value of an asset. Unfortunately for borrowers, their asset’s assigned value is more likely to be closer to its, “fire sale” value than to its fair market value. According to Ward, this is because “in a situation where the lender needs to sell the pledged collateral assets to recover the amounts loaned, they may underprice the assets for quick sale.”

It’s ultimately up to the lender to decide whether an asset qualifies as collateral. If lenders feel the assets do not have much value, or that the risk of defaulting is high, they will set a higher interest rate on the loan.

The takeaway

Lenders absorb less risk by asking for collateral. Because of this, secured loans are often one of the only options for borrowers with poor credit. Though borrowers risk giving up property or business assets to lenders if they default, putting up collateral can come with the advantage of lower interest rates and higher borrowing limits. If you need a loan, contact your financial institution and ask them to walk you through the options best suited for you.