Most people will need a loan at some point in their lives, whether it's for buying a home, starting a business or paying for education. In order to secure a loan, you have to show the bank or other lender that you'll be able to pay them back. After all, collecting interest on the money that they lend is how banks and other financial institutions make a profit.
In order to prove that you'll be able to pay back the loan amount and interest, most borrowers are required to provide proof of their income and their credit score, which tells the lender how past debt has been repaid. Sometimes, a bank will also require that you put up collateral.
What Is Collateral?
Collateral is something of value you own that you pledge as security for the loan. This means that if you stop making payments on the loan, the bank becomes the owner of whatever you've put up for collateral.
Some types of loans, like auto loans and mortgages, are secured. That means that there is something of value tied to the loan, and the bank can take ownership of it if you default. For example, if you stop paying your car loan, the vehicle will likely be repossessed.
Other loans, like business or personal loans, are unsecured. There is nothing of value inherently associated with the loan. In this case, the bank will often ask for collateral to be put forth to guarantee that if you stop paying, they will still recoup their money.
How Much Collateral Will I Need?
In general, your collateral will need to be worth more than the amount of your loan. For example, if you're using your home as collateral, many lenders will lend between 70 and 80 percent of the home's value less any other debt you have against the property, like a mortgage.
The exact loan to value ratio will depend on your unique circumstances. The lender will consider things like your creditworthiness (measured by your credit score) and what you intend to do with the money. For example, a lender may require that more collateral be put forth for a business start-up loan than it would require for a loan that will be used to expand an existing, proven business since the start-up is riskier.
How Do I Calculate Collateral Worth?
In order to know what to put forth as collateral for your loan, you'll have to calculate the collateral worth of your possessions using the same process the lender uses to determine the collateral worth. The first step is to determine the fair market value of your possession. Then, this is discounted by a certain percentage. For example, real estate is often discounted by 20 percent, so if your home is worth $200,000, it can likely be used as collateral to cover a $160,000 loan.
Collateral like business equipment might be discounted more steeply because it is more difficult to sell. Your lender should be able to help you understand how the market value of your collateral will be discounted.
Kelly Burch is a freelance journalist living in New Hampshire. Her writing on educational issues has appeared on Bright, The Washington Post, We Are Teachers and School Leaders Now.