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Consumer Credit: What Is Collateral?

Collateral is an item of tangible value which is utilized when procuring a loan to offset the risk a lender assumes should the borrower default. The most common types of collateral include property such as a home or automobile and investment assets like shares of stock. There are many different types of collateral which you may not be aware of both domestically and internationally but the key among all of them is that something of value is offered in exchange for a loan.

Collateral as a concept is very important in the financial industry because most loans and obligations are backed by assets and if the assets did not exist most financing would come to a halt. Lenders assume substantial risk by issuing loans to individuals and corporations whether it be $1,000 or hundreds of millions. Due to this risk lenders can ill afford to take substantial losses and then write them off the books or pursue legal remedies which could last years. When an asset is pledged as collateral against a loan the terms of the contract specify that should the borrower default they risk forfeiture of the asset to make the lender whole again legally and financially.

A very common scenario which most individuals and families will encounter is that of purchasing a home. Most consumers are unable to pay for a home in full with cash and therefore must seek a mortgage and spread the total cost of the home over 15 to 30 years. During that time the lending institution has taken the risk of giving a qualified individual a substantial sum of money and for that will receive interest payments every month until the contract is fulfilled in the loan is paid in full. If every single loan ever issued was repaid in full there would be no need for collateral but that has never been a reality. Consumers come under financial hardship such as job loss or extensive medical bills and sometimes get behind on mortgage payments. To protect the lender when a loan is issued, a lien is placed on the property and the title is held by the lending institution. Should the borrower default on the loan then the home can be foreclosed upon through a legal process and the homeowner evicted. The bank or credit union will then legally own the home considering they already paid for it with the mortgage and then will look to resell it to recoup any losses. Without this possibility to foreclose upon a property it would be almost impossible for any financial institution to issue mortgages to consumers.

One interesting form of consumer debt which is not backed by any form of collateral is the use of credit cards. Credit cards are not backed by any type of collateral and are often referred to as unsecured loans. The fact that credit card debt has no easily recoverable assets should the cardholder default is precisely why these types of loans carry higher interest rates. Mortgage interest rates can often be obtained for 4% on a 30 year loan while automobile interest can be as low as 2.5% for a six-year loan due to the underlying collateral. Credit card interest rates are often in the 10% to 12% range which makes them significantly more expensive than loans backed by collateral. Many consumers who are also homeowners will often qualify for a Home Equity Line Of Credit and then write checks when making purchases instead of using a credit card. Because a Home Equity Line Of Credit is backed by property, namely the homeowners residence, it results in a significantly lower interest rate and any interest that does accrue is tax-deductible. Why use a credit card at 13% interest purchase a hot tub when you can use a Home Equity Line Of Credit with a 6% interest rate instead.

Payday and title loans are another form of credit issued to consumers which uses an underlying asset as collateral. A payday loan requires the consumer to be currently employed and have a valid checking account at which point they provide their paycheck as collateral when obtaining a loan. A title loan, as the name implies, uses the title for an automobile as collateral against the loan. Title loans are especially bad for consumers because not only does the individual risk losing the title to their automobile and possibly their only mode of transportation but they also get charged exorbitantly high interest rates. This is contrary to how most collateral backed loans work as the lender assumes significantly less risk because of the ability to take possession of the vehicle so in reality the interest rate should be significantly reduced.

Collateral is a driving force in issuing loans to individuals and businesses and is used to offset the risk assumed by lenders should the borrower default. Loans can be obtained without the use of collateral but they often result in higher interest rates and stringent terms for the borrower. Owning personal property such as a vehicle or home has significantly more benefits than just something to drive or a place to live. Owning tangible assets leads to the ability to obtain other loans at better interest rates which you would not have had access to otherwise.