If you’re buying a home with a mortgage or refinancing, the mortgage lender needs to be confident you’re going to be able to repay the funds. A strong credit score and a history of smart financial decisions can provide some degree of assurance, but a lender also relies on the collateral that secures the loan — the home — to make the approve-or-deny decision.
What is collateral?
Collateral refers to an asset that a borrower offers as a guarantee for a loan, such as a mortgage. When you obtain the loan, the lender puts a lien on the collateral. The lien stipulates that the lender can seize the collateral if you don’t repay the loan under the terms of the contract. Once you repay the loan, the lender removes the lien and no longer has a claim to the collateral.
No matter what you use as collateral or what you want to do with the money you borrow, the definition remains the same: It’s your offering to help secure a loan.
How does collateral work?
Collateral applies to all kinds of secured loans, not just mortgages. (There are also unsecured loans that don’t require it.) For example, if you’ve paid off your car in full and the title is in your name, you can use that asset as collateral to borrow money for another expense. In this case, a lender can reasonably expect that you’ll pay the money back. If you don’t, the lender is legally able to take your car.
Collateral doesn’t necessarily have to be property, either. Some lenders let borrowers use their savings account as collateral. For instance, if you have $3,000 in your bank account or a CD, you might be able to use that as collateral to borrow more money. If you don’t repay the money you borrowed, the lender can take your cash in that account instead.
There are rules around how a lender can recoup losses, however, depending on whether the loan is a recourse or non-recourse loan.
- Recourse loan: With a recourse loan, the lender is legally permitted to pursue other assets or sue the borrower to garnish wages. So, if you don’t pay the loan back, you could lose your collateral along with future paychecks and other valuable property.
- Non-recourse loan: With a non-recourse loan, the lender has to absorb any difference between the value of the asset they seize and the balance on the loan. You still lose your collateral, but you don’t run the risk of losing other property or money.
How collateral works in the mortgage loan process