Collateral is an asset that a lender accepts as security for a loan. This means that if someone can not pay back a loan the lender gets the asset instead. Collateral can be real estate or other kinds of assets, depending on the loan. Collateral acts as protection for the lender. If the borrower defaults on the loan the lender can take the collateral so that the lender does not lose money on the loan.
How does it work?
Lenders want to make sure you have the ability to pay back the loan before extending one to you. That is why many lenders require some form of security to ensure they will not lose money on the loan. Collateral essentially minimizes the risk for lenders. It helps ensure that the borrower keeps up their financial obligation and is not encouraged to default on their loan. If the borrower does default the lender can take the collateral and sell it, applying the money it gets to the unpaid portion of the loan. The lender can also choose to pursue legal action to recoup any balance remaining.
Collateral can take many forms. It usually depends on the type of loan you are taking out. Mortgages are collateralized by the home, while car loans are collateralized by the car in question. Other nonspecific loans can be collateralized by other assets. Credit cards may be secured by a cash payment equal to that of the credit line extended.
You can also use future paychecks as collateral for short-term loans. Traditional banks offer such loans, usually for terms no longer than a couple of weeks. These are only an option if you are in a genuine emergency but you should be careful as the rates for these loans are usually high.
Loans without Collateral
If you want a loan without collateral you can take out an unsecured loan such as a student loan or personal loan. Unsecured credit cards do not require a deposit as collateral as secured cards do. Since there is no asset to seize unsecured debt generally comes with much higher interest rates and may be much harder to get. You would most likely need a much higher credit score to get unsecured loans because there is no direct security the lender has.
If you do not repay an unsecured loan or pay off credit card debt as required your credit score will suffer making it harder to get an unsecured loan in the future. You could also be sued for unpaid debt so it is important to take out loans only when you can pay them back.
Collateral is essentially a security that lenders have to ensure that they are not losing money on the loans they provide. Collateral can take the form of many different types of assets such as a house or a car. There are loans that do not have collateral involved but they require a much higher credit score to obtain and have much higher rates. It is always best to not default on your loan so you do not lose the asset you put up as collateral.