Collateral is the term used to describe an item that you are using for security on a secured loan. With a mortgage, the house you are buying is the collateral.
A house, a car, jewellery, even an expensive wine collection can all be used as collateral, but not all types of collateral are equal; some are better than others.
If you don’t keep up payments on your secured loan, the lender will get their money back by taking possession of and then selling the collateral.
There are at least 4 things that can affect how good an item is as collateral:
1. How easy is it to take possession of.
2. How easy it is to value.
3. How well it keeps its value.
4. How easy it is to sell.
The best items for collateral are those that are easy to take possession of, that are easy to value, that keep their value and are easy to sell. In this blog we will look at why this is the case.
Ease of possession
You cannot sell an item until you have taken possession of it. The easier the lender can take possession of the item, the cheaper and quicker they will get their money back.
It’s easy for a lender to take possession of a car, a tow truck arrives and impounds the car. Its slightly harder to take possession of a house, as you need to evict the people currently living in it. Imagine trying to take possession of a wine collection; where would you store the wine and how do you transport it!
Ease of valuation
The lender needs to make sure that the collateral covers the loan; so that if they have to take possession of it and sell it, they will get their money back. If something is harder to value, there is more chance that they will not get their money back.
Houses and cars are easy to value, lots of them sell every year which means there is good data to value them. It’s harder to value ewellery, you could use the wholesale price of gold…but that won’t consider the exact design and style…think about trying to value a wine collection!
Consistency of value
Some things go up in value, others go down. The lender needs to make sure that the value of the collateral is always above the value of the loan.
Houses not only keep their value but go up in value overtime; if the house covers the loan today, it will probably cover the loan in a years’ time. Cars, on the other hand, tend to reduce in value; the new car you put upas collateral is worth a lot less once you have driven it. If you value jewellery by the wholesale price of gold, you would see large movements from one month to the next (gold prices increased from $1472 per ounce on the 17thMarch 2020 to $2058 on the 6th august 2020). We have no idea how expensive wine changes in price!
Ease of selling
Once the lender has taken possession of the collateral, they need to get their money back. The easier it is to sell the item, the quicker they will get their money back.
Once lenders have taken possession of an item, they need to be able to get their money back. We all know the expression that something is only worth what someone is willing to pay for it. As a result, lenders tend to use auctions to sell items as this quickly gives the price people are willing to pay. There are specialist auctions for houses and cars; imagine trying to find an auction to sell a large wine collection.
