Definition
The term used to describe property or assets that are pledged as security against a loan is collateral. A secured loan is backed by property in the possession of the borrower.
Explanation
The use of collateral is important to the lending institution, since it gives them the ability to foreclose on a home, or repossess a car. Collateral reduces the risk of the loan, and results in lower interest rates passed on to consumers.
For example, a mortgage is a secured loan that uses the home itself as collateral. In the same way, writers of car loans use the car as collateral. If the borrower stops payment on their mortgage, home equity loan, or car loan, the foreclosed home or repossessed car can be sold. The proceeds from that sale can then be used to repay the remaining principal or outstanding balance, on the loan.
Unsecured loans, such as credit card debt and student loans, do not involve collateral. Repayment of borrowed money is less certain; therefore interest payments will be higher than secured loans.
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