If you are considering applying for a personal or business loan from a bank, the bank may require some sort of collateral as part of the approval process. Collateral is something of value that you own or control that you agree to hand over to the bank if you default on the loan.
If this sounds foreign to you, it is because this type of credit arrangement is not nearly as common as it was many years ago. Since ancient times, if you wanted to borrow money or something else of value, you were expected to leave the lender with something else of value (such as an animal or a costly garment) in expectation of taking the item back when you repay your loan. These days, however, it is far more common for loans to be secured directly by the asset being financed (like a house or vehicle), or by revolving, unsecured credit (like a credit card).
However, collateral is still very much a part of the lending world for those circumstances when the loan you are seeking cannot be directly secured by what you are purchasing. Repayment depends on what happens in the future. A sizeable personal loan for the purpose of debt consolidation, or a business loan to fund expansion are examples of this arrangement.
Understanding how collateral works and what sorts of assets qualify to serve as collateral can help you better decide whether a loan secured in this way is the right choice for you.
How is the value of collateral calculated?
Because collateral serves as risk reduction for the lender, it follows that no lender is going to allow you to borrow every penny that the collateral could possibly be worth. Most lenders will not even consider collateral that is not worth significantly more than the loan principal.
The calculation banks use to determine how much collateral they require is called the loan-to-value (LTV) ratio. In most cases, lenders prefer to lend an amount no more than 70 or 80 percent of the collateral value. For instance, if you have a collection of vintage Star Wars merchandise valued at $100,000, you may be able to use it as collateral to borrow as much as $80,000 in cash. (Note: if your bank’s loan officer is not a Star Wars fan, this option may not work.)
In that respect, this type of collateral works exactly the same as other secured loans, like an auto loan or a mortgage. In that case, the bank is only going to approve a mortgage up to a certain percentage of the value of the property being purchased. They are careful to do so because if you stop paying your mortgage payments and desert the house, the bank wants to ensure they can recover the full value of their loan by selling the house you have left them with.
What assets can be considered as collateral to secure a loan?
The following items are most commonly accepted as collateral for loans that require something beyond the asset being financed. It is important to note, however, that every bank (and every banker) is a little different, and they will all have their own requirements and/or preferences when it comes to what they will accept as collateral.
- Real Property: Land, buildings, vehicles, and land rights that you already own (not that you owe money on) is one of the most effective forms of collateral because it is relatively easy to sell and rarely depreciates significantly in value.
- Valuables: For similar reasons, valuable personal belongings (like art, antiques, gold, or jewelry) can serve as collateral as well. These items can generally be appraised by experts to determine their current and likely future worth with a fair amount of confidence.
- Cash: Perhaps the most popular form of collateral is cash itself, usually in the form of an existing savings account or easily liquidated investment account. While it may seem strange to borrow money if you have adequate cash on hand to serve as collateral, in the case of large investments, the dividends and interest income you lose by withdrawing that much cash can end up costing more than the interest on the loan.
- Future Income: Now we are moving into the realm of potential income, so lenders will view this sort of collateral as far more risky than the items above. However, if you are seeking a business loan and you have a high-quality business plan mapping out exactly what you intend to use the money for (and what the return on investment will be), you can convince a bank to lend you the money based on that alone. Or, they may accept future earnings as a portion of the collateral and require less in the way of real property or cash.
- Inventory and Equipment: For businesses that stock inventory (primarily retailers) and that own specialized equipment (such as manufacturers), these business assets can serve as legitimate collateral for a business loan. They may not be quite as fast to liquidate if the bank needs to seize them, but they are of value and of immediate use to your competition (if no one else).
- Invoices and Accounts Receivable: If your business has a strong history of collecting payment from customers and/or the customers who currently owe you for services rendered have a solid payment history, a lender may accept proof of the money you are owed as collateral. This form of collateral is usually used by businesses to get through a brief, temporary cash crunch so they can cover payroll and operating expenses while waiting for all their money to come in.
- Stocks, Bonds, and Other Investments: Most investments are treated similar to cash as long as the market is strong. Lenders accepting investment portfolios as collateral may even offer as much as 100 percent LTV if they are very confident in the market’s stability. In less certain economic times, however, those same lenders may remove this option from the table completely because of the risk. It is important to note that some investments, including personal retirement accounts and 401k plans, cannot legally be pledged as collateral to secure a loan.
- A Blanket Lien: As the name implies, a blanket lien covers basically all assets under your control, personal or business. Lenders are more likely to jump at this opportunity because it means that if you default on your loan they can go after anything and everything you have to get their money back. Doing so is very dangerous for the consumer. It should only be considered if all other options fail and securing your desired loan is crucial.
For more interesting and valuable financial insight, check out some of these past articles on financial success.