Definition: An asset a borrower promises that a lender may take if the borrower doesn’t pay back the loan.

Example: In school, when a student is looking to borrow a pen, pencil, or stapler for instance, the teacher may ask for collateral to make sure the student returns the pen.

While this is not a perfect example (the phone and pen are being temporarily swapped), it still shows how the borrower, Jack, gives his phone as collateral to promise that he will “pay” back the pen.

If Eric gets an auto loan for a Mercedes-Benz, the car itself is collateral. If he stops making his payments, the lender will send the “repo man” to take his vehicle. The bank will then sell the vehicle, hoping to receive at least the amount that it is owed.

Investeach explains: Notice how collateral acts like insurance. It insures payment of the loan. For this reason the risk of a loan with collateral is less than an uncollateralized loan. Less risk means that the lender is able to charge a lower rate of interest on a collateralized loan. This also explains why the interest rate on credit card debt (which has no collateral) is much higher.

Another term for a loan with collateral is a secured loan. The loan is secured by the collateral. The claim that the lender has to an asset that has been pledged as collateral is known as formally called a lien.

Riddle me this:

1. Why is the interest on a collateralized loan lower than on an uncollateralized loan?

2. What is another term for a collateralized loan?

3. Identify one example of a collateralized loan and one example of an uncollateralized loan.

Credits: Kevin Wang contributed to this definition.