What Does Collateral Mean for Mortgages?

In order to receive approval for a home loan, lenders need to be certain of your ability to repay the mortgage. A strong credit score and employment history is a great start, but your lender will also rely on the home you are buying in order to secure the loan.

Read on to learn what collateral means in relation to your home purchase, how it works, and the consequences of failing to repay your mortgage.

What does collateral mean?

Collateral, by definition, is any item that can be used as security for the repayment of a loan. This means that in the event you are unable to pay back a mortgage within the agreed term timeline, then the collateral is forfeited to the lender in lieu of payment.

For mortgages and home purchases, the property you intend to buy becomes the collateral for your home loan. Essentially, your lender will have a legal claim to the house (this is called a mortgage lien). Under the terms of your home loan contract, this gives a lender the right to seize the collateral if you are unable to repay the mortgage. However, once you have paid off your home loan, this legal claim is removed, and the lender will not have any rights to the property.

Why does collateral exist?

Collateral is used to secure a variety of different types of loans, but it exists for the same reason; to reduce the risk of funding for lenders. It ensures that the lender has a means of recouping their losses even if a borrower defaults on the mortgage.

How does mortgage collateral work?

While there are types of loans that do not require any secure assets (referred to as unsecured loans), there are benefits to having your mortgage secured with the home as collateral:

• Access to lower interest rates.
• Ability to borrow a larger amount.

This is also why home appraisals are required by most lenders. They will want to ensure they are not lending you more than what the home is worth, and if the appraisal comes back lower than the home’s market value, you will either have to negotiate the price down with the seller, find a different home, or pay the difference out of pocket. In some cases, your lender may decide to deny the mortgage outright since the collateral is not worth the risk.

In the event of a borrower defaulting on their mortgage payments, the lender can choose to foreclose on the home. While it is possible to negotiate a relief agreement with a lender, in most cases of foreclosure, you will have to vacate the property so it can be sold to recoup the lender’s losses. However, there are rules your lender must follow in order to recoup those lost funds. They are:

• A recourse loan in which the lender is allowed to pursue miscellaneous assets, including the home. Or they can sue a borrower in order to garnish wages (meaning future paychecks and other types of valued property).

• A non-recourse loan that involves a lender simply seizing the home and absorbing the difference in value versus the outstanding loan balance. In this case, you do not run the risk of losing other assets aside from the property you initially purchased.

When does a home go into foreclosure and how to avoid it

If you are unable to keep up with your monthly mortgage payments, or if you make late payments, or stop paying them altogether, then your lender may foreclose on the home. The foreclosure process varies depending on the state you live in, but on average it begins after home loan payments are 120 days past due. However, you will receive a notice of foreclosure from your lender before it is official.

Missing your mortgage payment by a couple of days will not automatically put you in danger of a foreclosure; however, you must make it within your lender’s defined grace period. You do need to act quickly in order to get your mortgage back in good standing. In the event of financial hardships, there are some options at your disposal that can help you avoid a foreclosure, including:

1. Do not ignore the problem. Contact your lender to discuss possible solutions or payment relief.

2. Applying for a mortgage forbearance that will temporarily pause or reduce mortgage payments during times of hardship.

3. Asking your lender for a temporary mortgage repayment plan if you experience a short-term financial setback.

4. Requesting a permanent loan modification.

5. Getting a deed in place of foreclosure.

6. Proceeding with a short sale that allows you to sell the house for less than the mortgage’s outstanding balance to pay to the lender, who in turn forgives any remaining debt.

In the event that a foreclosure is unavoidable, you will still have the option to file for bankruptcy. Though this may have a negative effect on your credit score and ability to apply for mortgages in the future, it may help you get out of a financial crisis. However, it is not recommended as a first choice option. It is important to stay in close contact with your lender, as they will be able to discuss the options you have at your disposal.

Collateral versus your mortgage: What is the difference?

Even though mortgage and collateral are two terms you will hear used in tandem, it is important to understand that they are not one and the same. Whereas your mortgage is used as financing for a home purchase, collateral is a separate asset that acts as backing for the mortgage.

In essence, in order to obtain a mortgage, you need collateral and, more often than not, the home you buy acts as the mortgage’s collateral.