What is collateral? Definition, examples and more

If you compare different types of loans, you might notice that secured loans like mortgages and car loans often have lower rates than unsecured loans and credit cards. 

One reason is because of collateral. But what exactly is collateral? And why do certain types of financing require it? 

Key takeaways 

• Collateral is an asset—like a car or a home—that can help borrowers qualify for a loan by lowering the risk to a lender. 
• Secured loans typically require collateral; unsecured loans usually don’t.
• Auto loans, mortgages and secured credit cards are examples of secured loans.
• Secured loans may have lower interest rates, thanks to collateral.
• If a borrower defaults on a secured loan, they could lose the collateral. 

In lending, collateral is typically defined as an asset that a borrower uses to secure a loan. Collateral can take the form of a physical asset, such as a car or home. Or it could be a financial asset, like investments or cash. 

Lenders may require collateral for certain loans to minimize their risk. Examples may include when a lender is financing a home loan or a car loan, or extending a line of credit to a borrower.

A lender may put a lien on the collateral. Once the loan is paid off, the lien will be removed. But if the borrower defaults, the lender could sell the collateral to help recover its losses.

Collateral can take many forms. It often depends on the type of loan. For example, when a mortgage lender issues a home loan, the house generally serves as the collateral until the loan is paid off.  

Other types of collateral may include:

• Real estate
• Vehicles
• Cash
• Investments
• Insurance policies
• Equipment and machinery
• Valuables or collectibles, like artwork

No, they don’t. To understand how collateral is used, it may help to remember that there are two basic types of loans: secured and unsecured. 

A loan that requires collateral is known as a secured loan, since the collateral acts as security for the lender in case of a default. Unsecured loans don’t require collateral.

Secured loans require collateral. Here are some types of secured loans.

Auto loans

Auto loans are a type of debt that may involve collateral. In this type of loan, the vehicle generally serves as the collateral. If the borrower fails to repay the loan, the lender may be able to repossess the vehicle to recoup some of the money for the loan.

Mortgages

Mortgages generally require collateral. In this type of loan, the home or property itself is used as collateral. Should the borrower default on the mortgage, the lender may be able to foreclose on the home or property.

Home equity lines of credit 

Home equity lines of credit (HELOCs) typically use a borrower’s home as collateral. The money from a HELOC is often used to pay for things like home renovations and improvements.

Like credit cards, HELOCs are an example of revolving credit. With a HELOC, a borrower can draw from a revolving line of credit, repay it and then draw from it again when they need more funds.

Home equity loans

Home equity loans are similar to HELOCs in that they both typically use a borrower’s home as collateral. Here’s one major difference: With a HELOC, a borrower is issued a revolving line of credit to draw from—but with a home equity loan, they’re provided with a lump sum to pay back over a fixed term.

Secured credit cards

If you have new credit or poor credit, secured credit cards might be easier to qualify for than unsecured cards. And with responsible use, a secured card can help you build or rebuild your credit history. With these types of loans, a cash deposit is used as collateral to open the account.

Business loans

Business loans, which can be used for things like buying equipment or funding company projects, are another type of loan that may require collateral. In this case, collateral may include assets like inventory or land.

Depending on your situation, there could be advantages and disadvantages to getting a secured loan. Here are some to consider. 

Pros of collateral loans

• They can help those with less-than-perfect credit or no credit history secure a loan. When approving a loan, lenders typically review a borrower’s credit history to determine their credit risk. If the borrower can provide collateral, it could help them get the loan—even if their credit needs improvement or they’re still establishing credit.
• They may offer lower interest rates. Secured loans can sometimes have lower interest rates than unsecured loans. That’s because the lender may be able to take possession of the asset to recoup their losses if the borrower defaults on the loan.
• Borrowers may qualify for higher loan amounts. Depending on the lender, borrowers can sometimes secure larger loans when using collateral as backing. The value of the asset may play a role in the total loan amount, too.  

Cons of collateral loans

• There’s a risk of losing the asset that’s been used as collateral. If a borrower defaults on a secured loan, the lender can repossess the asset to help make back their lost revenue. 
• The approval process can take longer. When using collateral to secure a loan, qualification may take longer than it does for an unsecured loan.

It’s important to understand how collateral works before you apply for a secured loan. One major reason: When you use collateral as a form of security, a lender could take possession of it if you default on the loan. 

While you're thinking about loans, it may help to review your credit scores and credit reports to better understand your financial standing. That’s where CreditWise from Capital One can help. It’s free for everyone, and using it won’t hurt your credit.