Understanding collateral is important when applying for a loan, as lenders often require it as security to minimize non-payment risk. So, what is collateral, and how does it work?
Collateral is an asset pledged by the borrower as a guarantee of repayment, which ensures the lender can seize and sell the said collateral to recover the debt if the borrower fails to repay.
In this article, we'll explore the meaning of collateral and its types, as well as answer questions like “What is a collateral loan?” and “What is collateral-dependent?”. Keep reading to learn more!
What Is Collateral and How Does it Work?
Collateral is an asset—such as real estate, a vehicle, or valuable property—that a borrower offers to secure a loan. It serves as a form of protection for the lender, ensuring that if the borrower defaults, the lender can recover the owed amount by claiming the collateral.
When agreeing on collateral, the asset pledged must be owned by the borrower and valued at least equal to, or greater than, the loan amount.
Here are some common scenarios where collateral is used:
Collateral Use Cases
Collateral mortgage loans—The property itself serves as collateral.
Auto loans—The financed vehicle is the collateral.
Secured personal loans—Borrowers use assets like savings accounts, stocks, or jewelry as collateral.
Business loans—Companies may pledge equipment, inventory, or accounts receivable as collateral.
Collateral is often formalized in a promissory note by outlining the specific repayment terms and clearly tying the borrower's obligation to the pledged asset. This legal document presents proof of the loan and ensures that if the borrower defaults, the lender has a written agreement to claim the collateral and recover the debt.
4 Types of Collateral in Loans
Various types of collateral can be used to secure loans, each with its own characteristics and considerations, including:
Types of Collateral in Loans
#1. Real Estate Collateral
Real estate is one of the most common types of collateral for loan agreements. This includes homes, commercial buildings, and land. Lenders prefer real estate because it usually holds its value well over time.
For example, a homeowner might use their house as collateral to secure a loan for renovations. If they fail to repay, the lender can foreclose on the property and sell it to recover the loan amount.
In the U.S., the Real Estate Settlement Procedures Act (RESPA) ensures that borrowers get precise information about real estate loans. It requires lenders to disclose important details about loan costs and terms, helping borrowers make informed decisions when using their property as collateral.
#2. Vehicle
Vehicles, including cars, trucks, and motorcycles, are commonly used as collateral, especially for personal loans. This process involves the borrower pledging their vehicle’s title to the lender. If the borrower defaults, the lender can repossess and sell the vehicle to recover the loan amount. It’s important to note that vehicles depreciate over time, which can affect the loan terms and the lender’s willingness to accept them as collateral.
Another example of vehicle-based collateral is title loans, a specific type of secured loan where borrowers use their vehicle title as collateral. This type of collateral is typically used for short-term loans and comes with high interest rates. If the borrower doesn’t repay the loan, the lender has the right to take the vehicle.
Title loan regulations vary by state. Some states have strict laws or bans to protect borrowers from high costs and unfair lending practices. For example, North Carolina and Ohio prohibit title loans altogether by capping interest rates and restricting the use of vehicle titles as collateral. Georgia, on the other hand, allows title loans but classifies them under pawnshop law, lending to extremely high interest rates.
#3. Inventory Collateral
Businesses can use their inventory—such as raw materials, finished products, or merchandise—as collateral for loans. This is especially useful for retailers and manufacturers that need extra cash to keep their operations running.
However, when deciding about collateral, lenders will evaluate the inventory’s value, how easily it can be sold, and factors like perishability or changing demand. For example, a retail store might use its current stock as collateral to get a loan for new seasonal products.
The Uniform Commercial Code (U.C.C.), followed in all 50 states, sets the rules for using inventory as loan collateral. Article 9 of the U.C.C. provides a standard legal process for securing and enforcing these types of loans, making it easier for businesses and lenders to operate consistently across different states.
#4. Accounts Receivable Collateral
Accounts receivable—money customers owe a business—can be used as collateral. This allows businesses to get cash quickly by using unpaid invoices to secure financing. Before accepting receivables as collateral, lenders check the creditworthiness of the business’s customers and how long the invoices have been unpaid.
Like inventory, accounts receivable are covered under Article 9 of the Uniform Commercial Code (U.C.C.).
How to Include a Collateral in Your Legal Contracts
To include collateral in your legal contracts, such as a promissory note or loan agreement, it’s essential to clearly define the asset being pledged and outline the lender’s rights if the borrower defaults. Typically, this information is included in a security collateral agreement or a collateral clause within a broader contract.
First, the agreement should specifically describe the collateral, whether it’s real estate, a vehicle, or inventory. Next, it should detail legal contract terms (the borrower’s obligations), including repayment terms and conditions for realizing the collateral. Finally, the contract should state what happens if the borrower fails to pay, such as repossession or foreclosure.
For example, a business loan security agreement might include provisions such as: “The borrower grants the lender a security interest in all current and future accounts receivable as collateral for this loan. In the event of default, the lender may take possession of the receivables to satisfy the outstanding balance.”
Collateral vs. Security: What Are the Differences?
Collateral and security are closely related in lending, but they serve distinct roles. Collateral refers to a specific asset a borrower offers to secure a loan. If the borrower defaults, the lender can claim the collateral to recover the loan amount.
On the other hand, security, or a security interest, is a lender’s right to claim the collateral if the borrower doesn’t repay the debt. This right is usually outlined in a contract, like a promissory note or a loan agreement. For the security interest to be enforceable, it often needs to be documented and, in many cases, filed with the appropriate authority.
In contract law, these legal security instruments help protect lenders while giving borrowers access to needed funds.
What Can’t Be Used as a Collateral?
Certain items cannot be used as collateral because they lack legal ownership, market value, or accessibility to the lender. For example, you cannot use future income, certain government benefits (like Social Security), or assets you don’t fully own.
If you lease a car, for example, you can’t use it as collateral since the leasing company retains ownership. Similarly, personal items with sentimental value but not market worth, like family heirlooms, don’t qualify.
Additionally, some retirement accounts and life insurance policies may be protected by law, preventing their use as collateral. Illegal assets are also prohibited, regardless of their perceived value.
What Happens to Your Collateral if You Can’t Pay the Loan?
If the borrower fails to make payments as agreed, the lender can seize the collateral by initiating legal proceedings, typically through a civil lawsuit, which generally involves the lender asking the court to sell the asset to recover the debt.
Once the asset is sold, the proceeds are used to pay off the loan. If the sale covers the entire debt, the lender keeps the funds to settle the loan. However, if there's any money left after the debt is paid, it will be returned to the borrower. On the other hand, if the sale doesn't fully cover the debt, the borrower may still owe the remaining balance.
Either way, failure to repay could result in losing the pledged collateral and potentially owing more than agreed, as legal fees can also be added to the total debt.
Create a legally sound promissory note with Contracts.net
Collateral plays a key role in securing a loan, and having a clear agreement helps protect both parties. With Contracts.net’s promissory note builder, you can easily create a document that outlines the terms of your loan and the assets being used as collateral.
Our tool simplifies the process, ensuring the agreement is clear, accurate, and legally sound!
Final Thoughts
Now that you're familiar with what collateral is, how it works, and its different types, you know that this form of security provides valuable protection in loan agreements.
Collateral gives lenders more confidence in repayment by offering a tangible asset as a safeguard. Rather than relying solely on a borrower's promise or financial stability, lenders have the legal right to claim the collateral if repayment terms aren't met.
This structure helps reduce risk, which makes the lending process more secure and predictable for both parties.
What Is a Collateral FAQ
Collateral in business refers to an asset—equipment or inventory, a company pledges to secure a loan or credit. If the business fails to repay the loan, the lender can seize and sell the collateral to recover the debt.
If you default on a loan with collateral, the lender can take legal action to seize the pledged asset. The collateral will then be sold to recover the particular debt, leaving you without the asset that is pledged as collateral.
Not all contracts require collateral. Collateral is typically needed for secured loans or agreements where the lender wants protection against non-payment risk. Most unsecured loans and other legal contracts do not typically involve collateral.
