If you are buying a home with a mortgage or refinance, the mortgage lender needs to be sure that you will be able to repay the funds. A strong credit score and a history of smart financial decisions can provide some degree of assurance, but a lender also relies on the collateral securing the loan – the home – to make the decision to approve or deny.
What is a warranty?
Collateral refers to an asset that a borrower offers as security for a loan, such as a mortgage. When you get the loan, the lender puts a lien on the collateral. The lien states that the lender can seize the collateral if you do not repay the loan according to the terms of the contract. Once you have repaid the loan, the lender removes the lien and no longer has a right to the collateral.
It doesn’t matter what you use as collateral or what you want to do with the money you borrow, the definition remains the same: it’s your offer to help secure a loan.
How does the warranty work?
The guarantee applies to all types of secured loans, not just mortgages. (There are also unsecured loans that don’t require it.) For example, if you’ve paid off your car in full and the title is in your name, you can use that asset as collateral to borrow money for a other expense. In this case, a lender can reasonably expect you to repay the money. If you don’t, the lender is legally allowed to take your car.
Collateral doesn’t have to be property either. Some lenders allow borrowers to use their savings account as collateral. For example, if you have $3,000 in your bank account or a CD, you might be able to use that as collateral to borrow more money. If you don’t repay the money you borrowed, the lender may take your money from this account instead.
However, there are rules on how a lender can recoup losses, depending on whether it is a recourse or non-recourse loan.
- Loan with recourse: With a recourse loan, the lender is legally allowed to seek other assets or sue the borrower to garnish wages. So, if you don’t repay the loan, you could lose your collateral as well as your future paychecks and other valuables.
- Non-recourse loan: With a non-recourse loan, the lender must absorb any difference between the value of the asset it seizes and the loan balance. You still lose your warranty, but you do not run the risk of losing other property or money.
How Collateral Works in the Mortgage Process
In the case of a mortgage, the security is the house, also called “real estate”.
When determining whether to approve your loan, the lender will order a home appraisal to ensure that the property – the collateral – is actually worth what you are offering to pay with the loan. If not, the lender may refuse the mortgage because the asset is not worth the risk.
On the other hand, if you don’t pay off the mortgage and can’t come to a relief agreement with your lender, the lender can foreclose on the home and you will lose that collateral.
Examples of collateral in the mortgage process
- To buy a house : When you buy a house with a mortgage, the house will serve as collateral for the loan. If you miss a certain number of loan payments – usually three to six consecutive months, but as soon as one payment is missed – you will be considered in default on the loan. Avoid this scenario at all costs, because this is when the lender can seize and repossess the collateral (your home).
- A home equity line of credit (HELOC) or home equity loan: You can use the equity in your home as collateral for a HELOC or home equity loan, which can help pay for other expenses. While there are some differences between a HELOC and a home equity loan, the main similarity is that you are putting your home on the line as collateral.
- Start your own business: If you are looking to start a small business, you may be able to use your home as collateral for a small business loan to lay the foundation for your new business.
At the end of the line
The concept of collateral can seem a little daunting – no one wants to consider the possibility of losing something of value, especially if it’s the roof over your head. However, the warranty plays a key role in helping you get the money you need to buy that roof. Whether you get a mortgage or any other type of secured loan, when a lender asks for collateral, make sure you have the means to repay the loan. Otherwise, this collateral could end up in the hands of the lender and you will lose this asset.