For instance, when you buy a home, the property is used as collateral to secure the mortgage. Before your home loan lender signs off on the mortgage, an appraiser will evaluate the home to ensure it’s really worth the price you’re paying for it.
How Collateral Value Works
For certain types of loans, your lender will require collateral to secure the loan. If you default on the loan—meaning you stop repaying it—your lender can seize the asset you used as collateral and sell it to recover the funds lost. Before your lender can loan you money, they first have to determine what the asset is actually worth. The fair market value of the asset is what’s known as the collateral value. You can determine the collateral value by either looking at what similar assets have sold for or having the item professionally appraised. A home appraisal is a good example of this. Home appraisals are conducted by licensed professionals who go through the property and determine how much it’s worth. They’ll consider things like the square footage, the condition, and the quality of the home. They’ll also look for any potential problems that will affect the fair market value of the home. The appraiser also looks at current market trends and compares the home to similar properties sold in that area. If the appraisal shows that the home is worth less than the sales price, the lender will likely only loan you the amount equal to the appraised value of the home. You may need to try and lower the price of the home or may need to put down more in cash.
Types of Collateral
Different types of collateral come with different requirements.
Real Estate
Real estate is one of the most common types of collateral used to secure a loan. It’s often used to secure mortgages, personal loans, and even business loans. For example, most borrowers use their property as collateral for a home loan when they purchase or refinance their home.
Vehicles
If your car has been paid off, you may be able to use it as collateral to secure a loan. You may also use the title to your vehicle to secure what is known as a title loan, though they are known for being expensive.
Cash
Some borrowers may decide to put down a certain amount of cash to secure a loan. For instance, you may be able to use the funds in your bank account to secure a loan. If you default, your lender has the right to liquidate your accounts to recoup the money they lost.
Intangible Assets
Intangible assets are sometimes used by tech companies trying to secure business loans. This includes things like software, trade names, and intellectual property. However, intangible assets may be harder for your lender to assess.
Inventory
Businesses that want to take out a small business loan will often use inventory to secure the loan. If you default on your loan, the lender can sell the inventory items listed as collateral.
Invoices
Businesses can also use outstanding invoices as collateral to secure the loan. If the business defaults on its loan, the lender can collect on the unpaid invoices. This is sometimes known as invoice financing or accounts receivable financing.
