Collateralization: Definition, How It Works, Examples

What Is Collateralization?

Collateralization is the use of a valuable asset as collateral to secure a loan. If the borrower defaults on the loan, the lender may seize and sell the asset to offset their loss.

For lenders, the collateralization of assets provides a level of reassurance against default risk. For borrowers with poor credit histories, it can help them obtain loans. Collateralized loans are considered secured loans, so they generally have substantially lower interest rates than unsecured loans.

Understanding Collateralization

A home mortgage and a car loan are two common examples of collateralization. The house or the car may be seized by the lender if the borrower defaults on the payments.

Collateralization is also common for business loans. A business owner may put up equipment, property, stock, or bonds as a security for a loan to expand or improve the business.

On a collateralized loan, the principal—the original sum of money borrowed—is typically based on the appraised collateral value of the property. Most secured lenders will lend about 70% to 90% of the value—known as the advance rate—of the collateral.

For a lender, collateralized loans are inherently safer than non-collateralized loans, so they generally have lower interest rates. Non-collateralized, or unsecured, loans include credit cards and personal loans, which generally have much higher rates.

Interest Rates for Collateralized vs. Unsecured Loans

For example, as of August 2023, here are sample interest rates for collateralized vs. unsecured loans:

• Collateralized: An 36-month auto loan for a new car could be obtained at an average interest rate of 7.91% by an applicant with a good credit rating.
• Collateralized: A 30-year fixed-rate mortgage could be obtained for an average interest rate of 7.23%.
• Unsecured: On the other hand, the median rate of interest across all credit cards in the Investopedia card database was 23.99%.
• Unsecured or secured: Interest rates for personal loans, which can be either collateralized or unsecured, ranged from 4.6% all the way up to 36%.

Collateralized Business Loans

When companies need loans to finance projects and operations, they can use equipment and property as collateral to secure bonds that are issued to investors as fixed-income securities. Fixed income provides investors with fixed interest payments as well as the return of principal at maturity, so bonds are a type of collateralized loan (corporate debt) between the company (the borrower) and the investor (the lender).

With bond offerings, the equipment and property is pledged as collateral for the repayment of the bond. In the event of the company's default, the underwriters of the deal can seize the collateral, sell it, and use the proceeds to repay investors.

The increased level of security offered to a bondholder (the lender) typically helps to lower the interest rate offered on the bond, which also decreases the cost of financing for the issuer (the borrower).

Collateralized Investing: Buying on a Margin

In the investment industry, using securities as collateral is common. For example, buying on a margin, which means buying (in part) with borrowed money, is based on the use of other securities in the investor's account as collateral on the loan. If the investor has sufficient assets in the account to use as collateral, a brokerage firm will allow that investor to buy securities with borrowed money.

If the investment is successful, the loan will be repaid from the profits. If the investment loses money, the broker issues a margin call, (i.e., a demand for the investor to either deposit additional money or securities or sell some of the assets to bring the account up to the minimum value).

Typically, margin calls are for a percentage of the total amount borrowed. If an investor borrows $1,000, the brokerage would require that 25% of the loan ($250) be available as collateral. Thus, it's essential that investments bought on a margin increase in value for a positive return.

The Bottom Line

Secured loans use collateralization to protect the lenders in the event of a default. If you have something of value and you're confident of your ability to repay your loan, you can leverage your collateral to get a much lower interest rate than you could on an unsecured loan. Just borrow wisely—if you can't repay a loan that is secured by your house or car, you may find yourself without shelter or transport.