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What Is Collateral and How Do Collateral Loans Work?

  • 7 MIN READ|
  • 0 Comment |
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  • by Joseph Priebe|
  • March 28, 2019 |
  • Loans

How do collateral loans work?

There is a fable of sorts that’s taught in high school and college economic courses. It details the basic tenant of how economics works – not just in a capitalist free market society, but in any society where goods and services are produced; in other words, any society – and the fable ends with a cliché you’ve probably heard a hundred times over.

Let’s begin with the fable first.

A long time ago, a King was having difficulty understanding why his country was coming out on the losing end of trade negotiations. No matter how much his realm produced, the royal treasury never seemed to reflect many transactions, nor the value of the goods produced. So the King called for his most trusted advisers.

“Tell me how the economy works,” he commanded.

His advisors began a very detailed and complicated explanation involving market value, one good’s price versus another, market saturation being the cause of lower prices, the advantage of bulk selling at lower prices as opposed to selling smaller units at higher prices, and the concepts only got more complex from there.

“Halt!” The king commanded, having gotten lost well before he spoke up. “I need these concepts to be simplified.”

The advisers collaborated for a few minutes and then began again. Once more they expounded on the necessities of supply versus demand, why some goods were worth more than others, and why it is sometimes necessary to have a smaller supply even when demand increases.

Again, the king was frustrated. “There must be a simpler way to explain this.”

Huddled together, the advisers whispered frantically for many minutes while the court patiently waited for their conclusion. Finally, heads within the huddled circle nodded, and the chief adviser stood up and faced the monarch.

“Sire,” he began, somewhat nervous. “Economics can be explained thusly: there is no such thing as a free lunch.”

That, of course, would be the cliché you’ve heard time and again, but there’s a chance you might not have been able to grasp its entire meaning. Essentially, that cliché is the same as another one you may have heard: You can’t get something for nothing.

The meaning boils down to this: in every economy, there is a value for every service or good produced. Even if you show up to a free buffet and eat your fill, someone’s labor and expense went into paying for that buffet. Even in anti-capitalist markets, barter systems and centralized government-run economies place a value on every possible good and service that can be produced.

In the case of the service that involves lending money, much of the value placed on that loan depends on what kind of collateral can be offered in exchange.

Why Collateral Loans Exist

Loans cannot be given away for free. Perhaps that sounds like stating the obvious, but a loan without terms is a gift, and there is no obligation for the receiver to pay it back. Many people think the idea of collateral is about trust, but this is not the case at all. Many people can prove they are the most honest and trustworthy citizens in the country, but that doesn’t mean a loan can be given without securing collateral.

Since loans are a service that has a value attached, there must be a certain ‘common’ standard value for any given loan. For the United States, the Federal Reserve Banks set that standard by raising or lowering interest points which in turn determine what interest a bank will charge for a loan. The Federal Reserve is the regulating branch of the federal government that monitors financial institutions and makes sure they engage in fair banking and lending practices.

This is necessary because, without such regulation, banks and other lending institutions could charge outrageous interest points on a loan, or change the terms of a loan on a whim. If you’ve seen some of the more popular mafia films and television programs, you’ve had a glimpse at what such terms could look like. It sounds far fetched, and to a degree it is, but note that there was a time in recent history when someone who failed to pay their debt in a reasonable amount of time had all their possessions confiscated and were often thrown into debtors prison.

So, to borrow a sum of money, there must be something of worth to stand as collateral. This is important because it not only brings a sense of security to the loan, but it gives collateral loans value. For example: if you borrowed a thousand dollars tomorrow at 5% interest, then that is the value of your loan. If next week interest rates went up to 6%, your loan has extra value because you borrowed when rates were lower, and your rate cannot be changed. The 5% loan is more valuable than the 6% because it costs the lender less to pay off.

What is Collateral?

Collateral serves many functions in the process of a loan. It provides security, value, and also tends to provide motivation for the borrower to pay off the loan promptly. If you borrow money against the value of your house (often called a second mortgage), then you will be motivated to pay back that loan to keep the house you used as collateral. As much as this might sound like those times in recent years when someone could lose their possessions, it is different. The borrower voluntarily puts up their home as secure collateral against the loan, and (presumably) understands the terms of the loan, which include giving up ownership of whatever collateral has been put in place.

This, of course, assumes there is no renegotiation of the original loan. Often the lending institution is willing to renegotiate the terms to let the borrower pay off the loan (with an additional point or two in interest) and keep whatever collateral was put up for the loan in the first place.

Remember our fable at the beginning of this article? There’s no such thing as a free lunch. If collateral loans are not paid off, then value of that loan must be satisfied in order to keep as much economic stability as possible. You might be thinking this is all based on perception, and you would be right. As long as the general public’s perception is that loans are being offered and paid off, then the economy as a whole can function properly. 

Now, you may be thinking that there are hundreds of thousands of loans taken out every day in the United States and you would be right. You might also be thinking that one loan that goes unpaid will not affect all of these others, and you would be partially right. But again, we are talking about perception. If it is believed that loans can be ignored, then the value of the currency that loan is based on becomes devalued, interest rates go up, markets fluctuate, and sometimes they crash.

If you are wondering about what the current state of unpaid loans is in the United States (not counting the National Debt), there are no single statistics available that totals up that amount. But here’s an idea regarding one certain aspect of the economy regarding unpaid debt: as of this writing, the United States holds 1.2 trillion (with a “T”) dollars in unpaid student loan debt. That has a major effect on the economy, as demonstrated here. Now, this might not affect you directly, but it will certainly cause not only interest rates on student loans to rise, but tuition fees as well, making it much more expensive for your children and grandchildren to attend college than it was for you, or is for the current generation of students.

Here’s another way to look at it: If you’ve seen the classic movie ‘It’s a Wonderful Life,' then you might recall the point when the main character George Baily was just about to head out on his honeymoon. As he and his new wife were driving out of town, they noticed a line forming at the bank. The reason was that the stock market had crashed, and people’s perceptions were that the banks were low on money, so they decided to get theirs out before they couldn’t. That’s called a ‘run,' when customers develop the impression that their bank is no longer solvent and they try to withdraw their money. 

Now, if you are familiar, with the movie, you’ll remember that there was a line at the Building and Loan and George Baily put up $2,000 of his own money in order to give people small loans to tide them over. He had two dollars left, and as he put them in the vault, he told them they better start reproducing right away. Now, of course, money doesn’t just spontaneously come into existence. What Baily meant was that as long as people paid off their loans with interest, the Building and Loan would be solvent, and confidence in the economy would remain relatively stable.

What Does All This Have to Do with Collateral Loans?

Collateral, if it is taken in place of an unpaid loan, can provide the bank with at least a partial repayment value of the loan, and the loss does not have to be total. But of course, it’s always better to pay off the loan; you get to keep your collateral, your credit improves, and the economy functions in a healthy manner.

One of the most amazing aspects of our particular economy is that anything of value can be used as collateral. From the most valuable of assets – that being property – all the way down to things like collectibles and heirlooms that have monetary worth. You can get a second mortgage on your home if you own it. You can get a title loan based on the worth of your car if you own it outright, or a value equity loan based on what you have left on your car payments plus what your car is worth. You can get an equity loan based on stock (particularly the worth of the stock) all the way down to small loan amounts. These can be based on your paycheck, savings account, or the comic books you’ve had laying around for decades (though for things like comic books, pawn shops are the best place to get a small loan).

Places like CASH 1 deal in personal loans near me based on the equity of your paycheck, or car collateral loans based on the worth of your vehicle, and it doesn’t just have to be a car. You can get a title loan based on an RV or motorcycle. And the best part is you get to keep using the vehicle while the loan is being repaid.

It is important to remember that institutions like CASH 1 are not interested in getting your car or motorcycle. Those things are used to provide security and collateral value to the loan. It is much more preferred that you pay off your loan and get to keep your vehicle, that way you can get another title loan in the future if you need one, and lending institutions don’t have to go through the hassle of collecting your collateral and selling it. 

The goal is to get you much-needed money based on the worth of your collateral, not to take possessions of the things you need to hold on to, which is why in many cases collateral loans can be renegotiated for new terms if you ever have trouble paying it off. But in such cases, it is important to keep in communication with your lending institution to keep them updated should any circumstances arise in which you need to discuss new terms for your loan.

It is a myth that places like small loan institutions exist to take possession of your collateral. It is in the best interest of both parties that the loan is paid off, and there are ways this can be accomplished without losing the car you need to commute to work.

If you think a title loan might be right for you, see us at CASH 1 for loans near me, or call us at 844.831.4198 and we will work with you to get a fair and equitable loan based on the value of your collateral.

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