Definition - What does Collateral mean?
Collateral includes any asset or property which is offered to secure a loan. The collateral offers security to the lender, allowing the lender to repossess the property in the event that the borrower fails to follow the terms of the lending agreement. If the borrower does not make the agreed upon payments, the lender is legally allowed to repossess the collateral, sell it, and use the proceeds from the sale to repay the debt.
Collateralized loans, also referred to as “secured” loans, generally have a lower interest rate, which reflects the protection the lender has that they will not lose all of the money owed. In some cases, the collateralized item will not be repossessed, but instead, the lender will place a lien on the asset. The lien then must be cleared or paid before the borrower can sell it.
What are the most common secured loans?
The most common secured loans are loans made to purchase cars and homes. If a borrower has a mortgage, which is the loan to purchase a home, and they fail to make their mortgage payments, the lender has the legal right to repossess the house, also referred to as foreclosure. Generally after the lender has foreclosed on the house they will auction it or resell it, using the proceeds from the sale to repay the debt owed.
Car loans also function in a similar manner with the lender repossessing the automobile if the borrower fails to make their monthly car payments.
Collateralized loans vs. Unsecured loans
While collateralized loans are secured by assets which can be sold to help the lender recoup the costs of the loan, an unsecured loan (i.e., credit card debt, unsecured personal loans, and medical debt) are not secured by assets. For example, if you have accumulated medical debt for a surgery there is nothing the lender can “repossess.”
Not only do unsecured loans have a higher rate of interest, which reflects the increased risk for the lender, many unsecured loans can also be discharged in Chapter 7 bankruptcy. Secured loans, however, are never discharged. If Chapter 7 bankruptcy is filed the secured asset is generally sold and the proceeds used from the sale to repay the creditor. If the sale does not cover the full cost of the secured loan the remaining amount, referred to as a deficiency judgment, may be discharged in the bankruptcy.