Your home does become collateral when you take out a mortgage. While this makes foreclosure possible it also enables the bank to offer very low long-term interest rates for the purchase.
- Collateral is an asset you pledge as security for a loan.
- Banks use your home as collateral for home loans.
If you handle your finances properly and buy an appropriate house for your budget, you probably will make timely payments and never have to worry about foreclosure. Even if you have an emergency, the bank never wants to foreclose and most have programs to help you get through the crisis and back on track. Therefore, you should not worry about needing to use your home as collateral for the mortgage.
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What is Collateral?
Collateral is an asset that you pledge as security for a loan. If the lender accepts the asset as security, then they have the right to take it if you default on your loan. Collateral:
- Can be any item of value that the borrower and lender agree upon
- Is protection for the lender
- Is at risk for the borrower if they don’t meet their financial obligation
For big-ticket items, such as a car or house, banks usually require that the item itself is the collateral for the loan. In such cases, if you don’t diligently pay down your loan the bank will foreclose and take your house or repossess your car. In other cases, the lender may want different collateral, usually a savings or investment account.
How Does Collateral Work?
Collateral has a very important function in financial markets. For lenders, it guarantees that even if the loan goes bad, they will get an asset. For borrowers, it incentivizes them to keep up payments on their loans.
If the borrower makes timely payments, then the lender has no direct claim on the asset. However, if the borrower defaults:
- The lender can seize the asset and sell it to recoup damages.
- If the sale of the asset does not cover all the losses the lender can take legal action to recover any remaining balance.
What does this mean for you, the borrower? Substantially lower interest rates. Secured loans (i.e., with collateral) are far safer for banks than unsecured debt.1
How Does Collateral When You Take Out a Mortgage Affect Interest Rates?
Since collateral provides security to banks, they offer much lower interest rates for secured loans. How much lower? I found some loan terms for secured and unsecured debts at the time I’m writing this in February 2021.
- Citi Diamond Preferred Card (Unsecured) – Variable annual percentage rate (APR) is 14.74% – 24.74% for outstanding balances based on credit scores.2
- A 30-year fixed-rate mortgage with 20% down (secured) – ~3% depending on lender and underwriting terms.3
- Auto loan for up to 84 months (secured) – 2.5% with good credit.4
As you can see, collateral makes a big difference in how much interest you must pay for a loan. In fact, when I purchased a car this month, the dealer I buy from offered 0% interest on a 48-month loan for one model car as a special promotion.
Do Mortgages Use Your Home as Collateral?
Your mortgage company does require you to use your home as collateral in order to underwrite a loan. As we discussed earlier, it is the reason you can get a low-interest rate for the loan. Without using the house as security, you would have to put up something else of equal value that the bank will accept. For most people, this isn’t possible. Otherwise, you will have to pay a much higher interest rate. In fact, the interest rates would be so high that few people would be able to pay them.
It is common for people to default on unsecured loans and banks have little recourse to recoup their losses. With your home as security for the loan, the bank will be willing to grant a much lower interest rate. Even so many people still default on their loans. Therefore, banks carefully inspect the value of the property to ensure they can sell the property at a minimal loss if they must foreclose. They require:
- Home inspection
- Title search
They may also require a survey of the property, especially if there isn’t a current one or if there is a question about the boundaries. This underwriting process can take a few weeks to complete.5
Is Collateral a Down Payment?
Collateral is not the same thing as a down payment. The money you put down secures the real estate transaction. It is made with the seller of the property, but it is very important to the lender as well. Collateral is the asset you provide to secure the loan.
- Down payment counts toward the purchase price.
- A down payment is your initial ownership stake.
- Collateral does not count toward the purchase price.
- Collateral does not affect your ownership stake in the property; it only secures your loan.
If you put 20% down on a home, you have 20% ownership. Collateral, however, doesn’t affect your ownership that way. It only comes into effect if you default on your loan. Then, your lender can sell the property you put up to secure the loan to recoup losses.
How Much Collateral do I Need for a Mortgage?
Mortgages companies want you to provide 100% collateral to secure a mortgage. In fact, they require documentation to prove the property is worth as much as the loan. They usually require a(n):
- Title search
- Survey if there is not a recent one available.
The bank won’t loan more than the value of the property, because if you default, they can’t recoup their money. This is one reason your lender cares how much you put down. The more you put down, the more wiggle room you have if the appraisal comes in low.
The other reason the bank wants you to put down 20% is to show that you are responsible with your finances. It takes time and discipline to save that much money, but most banks will still make the loan if you pay for private mortgage insurance (PMI). In fact, HUD and the VA have programs that help homebuyers who don’t have 20% avoid PMI.
Final Thoughts on Your Home Becomes Collateral When You Take Out a Mortgage
Your home becomes collateral when you take out a mortgage to protect the bank’s investment. While it may sound scary that you can lose your home, the bank won’t foreclose and take your house if you make your payments on time. In fact, even if you fall behind because of hard times almost all banks have programs to help you get back on track without losing your home.
The reason the market is set up this way is so that banks can offer very low interevent rates for home loans. The benefit to the risk of foreclosure is very good financing terms. You should carefully consider the risks and benefits of homeownership before you buy a house. It likely will be your biggest purchase, and it is a big responsibility.