by Michael Totten

Created on: February 26, 2010

Collateral refers to personal property that serves as the borrower's pledge to repay secured credit. These properties may consist of real estate, physical items, commodities, securities, liquid assets such as cash on hand, or anything else acceptable to the lender. If the secured loan is not repaid, the borrower defaults and the collateral becomes the property of the lender.

The most familiar example of collateral is the real estate being acquired with a mortgage loan. In this case, the house itself is the collateral for the loan being used to purchase it. Failure to meet the terms of the loan results in foreclosure, in which case the house becomes the property of the mortgage lender.

Collateral values

The value of collateral is not usually calculated at its fair market value. The lender must take into account a variety of factors ranging from standard depreciation over the life of the loan to what it will cost to liquidate the asset if the borrower defaults. Other liens against the property must also be subtracted before it can be accurately evaluated as collateral. This usually results in high devaluation, high lien properties, such as personal vehicles, having a very low value as collateral.

In most cases, the value of the collateral will be greater than the value of the loan. This is by design. Property values fluctuate, and collateral must not only provide surety that the borrower will try to repay but also surety that the value of the loan can be recovered. Standard valuation of collateral allows for expected fluctuations in the value of property. Creditors are considered adequately secured so long as the value of the loan is less than the value of the collateral securing that loan.

If the value of property falls to below the value of the secured loan, the creditor is now undersecured, or "underwater." What happens in this case depends on the type of loan. In many cases, the lender will let the difference slide as long as the borrower follows the schedule of payments. Rarely, the terms of the loan may require the borrower to make up the difference in collateral value, lest the loan be rendered null and void.

Losing collateral

If the borrower defaults on a secured loan and the value of collateral is less than the value of the loan, the collateral is sold and applied to the loan. Whatever debt still remains after that is called a deficiency.

Most types of loans require the borrower to make up the deficiency from other property. A few types of loans are covered by anti-deficiency laws, which prohibit the creditor from collecting a deficiency. This kind of debt is called a non-recourse debt. Non-recourse debts are most common among mortgages for the primary dwelling.

Anti-deficiency laws vary from state to state, and several states planned to change their anti-deficiency legislation in 2009 and 2010 to take the real estate crisis into account. For example, Arizona's updated anti-deficiency legislation (A.R.S. 33-814(G)) requires that the borrower must have utilized the property for six consecutive months, with a certificate of occupancy having been issued. This change makes defaulting real estate investors liable for any mortgage deficiency after foreclosure.

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