What Is the Importance of Collateral?

If you default on your car loan, the lender will seize the car.

When applying for a loan, you may notice that secured loans typically offer better terms than unsecured loans. Lenders of secured loans can provide borrowers with lower interest rates and longer loan durations because they have collateral, which makes the loan a safer investment for the lender.

Definition of Collateral

Collateral refers to assets or personal property that you use to secure a loan. For example, you typically secure a mortgage by pledging your home as collateral. If you default on a loan secured with collateral, the lender can seize the collateral and sell it to repay the debt. Other examples of loans secured with collateral include car loans and home equity loans.

Advantages for the Lender

If the borrower defaults on a loan secured with collateral, the lender can seize his property to repay the debt. However, lenders of unsecured loans must obtain a judgment before they can seize property. Moreover, lenders of unsecured loans cannot seize property that the borrower has used to secure another loan, so they typically don't have access to many of the borrower's major assets, such as his home or vehicle.

Probability of Repayment

A loan secured with collateral is a better investment for the lender because borrowers don't want to lose their pledged property, so they are less likely to default on the loan. If a borrower has multiple debts and cannot afford his payments, he will typically make payments on the secured loans before he pays unsecured loans and other bills.

Advantages for the Borrower

If you have bad credit or limited income, lenders may be more willing to approve your application if you agree to pledge collateral. If you don't have traditional collateral, such as a vehicle or home equity, some lenders may accept other forms of collateral, such as jewelry. Even if you have the credit and income to qualify for an unsecured loan, secured loans often feature lower interest rates, and the lender may allow you more time to repay the loan.

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