Backing a loan with collateral gives the lender a security interest in an asset if the borrower defaults on the loan. The asset classes that can serve as collateral for a loan include real estate, bank accounts, collectibles, vehicles, commercial equipment and precious metals such as gold. In the event of default, the lender can seize or repossess the asset backing the loan to recover a portion or the entire amount that was borrowed. Generally speaking, the asset classes that can be used to collateralize a loan will be determined by the type of loan and the nature of the lender.
Collateralized Loans with Large Banks
Since the banking crisis that started in 2008, large institutions have become more careful about the types of collateral they will allow to back a loan. Real estate is still the most common form of collateral, with loans taken out in the form of first and subordinated mortgages as well as home equity lines of credit. Vehicles, savings accounts and certificates of deposit can also serve as collateral for loans. Generally speaking, assets that the bank can place a lien against, such as residences and vehicles, are readily accepted as collateral. Assets that are easy to value and liquidate, such as stock portfolios and in-house savings and CD accounts, can also be used to collateralize loans.
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Loan Collateral and Unregulated Lenders
Unregulated and private lenders, also referred to as hard money lenders, can accept any type of collateral they deem as having enough value to secure the loan. While these types of lenders can use a wide range of assets without needing to justify them to regulators, placing accurate values on the collateral is essential to protect the loan portfolio. The lack of regulation on these lenders can result in faster approvals, but interest rates on loans are usually higher than those from conventional lenders. Private lenders will usually permit the same types of assets as regulated institutions, but may also allow gold, jewelry, high-demand season tickets, and collectibles to be used as collateral for a loan.
Preferred Types of Collateral
For lenders, the best types of collateral are those that can be quickly converted to cash in the event they have to be sold as the result of a default. Illiquid forms of collateral can pose challenges to lenders in terms of valuation as well as with selling assets. For example, equipment that has specialized uses may have a limited number of buyers. This can result in heavily discounted prices if there is a market at all. Doubts on liquidity and pricing add risk for the lender, which usually results in higher interest rates on the loan. A second disadvantage of illiquid collateral is that a substantially discounted value may require additional assets to be pledged by the borrower, which puts more at risk in the event of a default.
There are situations where the relationship between the lender and the borrower can create opportunities to use nontraditional collateral to secure a loan. These relationships may have a long history in which the lender has provided financial services to a family for generations, or the prospective borrower is a large client of the bank. In both situations, lenders typically do their utmost to satisfy the borrowing needs of valuable customers to prevent them from going to another institution for financial services. For example, to meet the needs of a client seeking to use an extensive wine collection as collateral for a loan, a lender may bring in an outside appraiser to determine the value as well as the liquidity of the pledged assets.