Why Do Banks Require Collateral to Make Loans?

by Neil Kokemuller ; Updated July 27, 2017
Banks require collateral when the risks of offering financing are otherwise too high.

Banks require collateral on certain types of loans when the loan amount, borrower's credit worthiness and other risk factors pose too great of a threat to the lender without security. Mortgage loans and car loans are two common consumer loans that require collateral. Business property and major asset loans also commonly require collateral. A borrower actually benefits financially in some ways by providing collateral on a loan.

Loan Basics

When banks issue loans to consumers and businesses, they charge financing fees that sometimes include up-front fees, as well as ongoing financing fees, based on an established interest rate. In general, a loan that is more risky to the lender means a higher cost to the borrower. When unsecured, a loan is typically issued based on the borrowing credentials of the consumer or business. Having a good credit score makes getting affordable unsecured credit possible.

Offsetting Lender Risks

Lenders use collateral to offset the risks of financing when they are too great to issue financing. Home mortgage loans, equity loans, car loans and business loans are all examples of loans that require collateral. Giving financing to a borrower to purchase a home, for instance, is a huge investment. A lender takes a conditional ownership claim known as a lien, which is a virtual backup plan should the homeowner fail to meet his loan repayment obligations.

Secured Loan Disadvantages

Putting up collateral to secure a loan is sometimes a scary proposition for people. If you do not fulfill your loan commitments, you risk losing your home, car, boat or whatever else you used to secure the loan. Not repaying your mortgage loan could cause your lender to foreclose on your property to take possession. With an auto loan, the lender can repossess your car as soon as you fail to meet the repayment obligations outlined in your loan contract.

Secured Loan Benefits

Secured loans do have some significant benefits for borrowers. People with bad credit are often able to get loans with collateral that they otherwise could not get. Rates are typically much better on a secured loan as well. Getting a home equity loan to complete a major home project or to start a business is usually much less expensive than getting a personal, unsecured loan with a higher interest rate.

About the Author

Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.

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