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If you’re using a mortgage to buy a home, the lender needs to be confident you’re going to be able to repay the funds. A strong credit score, steady income and good history of debt management 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 for a mortgage loan?
Collateral refers to an asset that a borrower offers as a guarantee for a loan or debt. For a mortgage (or a deed of trust, exclusively used in some states), the collateral is almost always the property you’re buying with the loan. Obtaining the financing puts a lien on the property.
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 property.
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 mortgage collateral work?
In the case of a mortgage, the collateral is the home, also referred to as “real property.”
When determining whether to approve your loan, the lender will order an appraisal of the home to ensure that the property — the collateral — is actually worth what you propose to pay for it. If it isn’t, the lender can deny the mortgage because the asset isn’t worth the risk.
On the other side of things, if you don’t repay the mortgage and can’t come to a relief agreement with your lender, the lender can foreclose on the home, and you’ll lose that collateral.
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, in addition to the home, 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.
Difference between collateral and mortgage
You’ll often hear the terms “collateral” and “mortgage” used in the same sentence or in similar contexts, but it’s important to understand the differences.
A mortgage is a type of loan that you can use to finance the purchase of a property. Collateral is an asset that provides the backing for a loan — any sort of loan.
You almost always need collateral to get a mortgage and that collateral is almost always the property you’re buying with the loan. Think of it as a mortgage being a debt and collateral being the thing mortgaged — and a demonstration of how serious you are about paying that debt.
Examples of collateral in the mortgage process
- Buying a home: When you buy a home with a mortgage, the home will serve as collateral for the loan. If you miss a certain number of loan payments — typically three to six months in a row, but it can be as soon as one missed payment — you’ll be considered in default on the loan. Avoid this scenario at all costs, as that’s when the lender can foreclose and take back the collateral (your home).
- A home equity line of credit (HELOC) or home equity loan: You can use the equity (ownership stake) you have in your home as collateral for a HELOC or a home equity loan, which can help pay for other expenses. While there are some differences between a HELOC and a home equity loan, the key similarity is that you’re putting your home on the line as collateral.
- Starting your own business: If you’re looking to launch a small business, you might be able to use your home as collateral to secure a small business loan to help lay the groundwork for your new venture.
Bottom line on collateral in mortgages
The concept of collateral might sound a bit daunting — no one wants to entertain the possibility of losing something of value, particularly if it’s their home. However, collateral plays a key role in helping you secure the money you need to buy that home, and to repay it over a series of years. Whether getting a mortgage or any other type of secured loan, when a lender asks for collateral, make sure you have the means to pay the loan back. Otherwise, that collateral could wind up in the lender’s hands, and you’ll lose the roof over your head.