In the first two installments of our “Three Cs of Credit” series we discussed how character and capacity are essential in obtaining a favorable loan or line of credit.
Though assessing a borrower’s character and capacity is crucial for a loan officer to determine the approval and terms of a loan, the borrower may also have to put up collateral (the third element in the “Three Cs of Credit”) to help secure the loan.
In the context of credit collateral means of, relating to or guaranteed by a security pledged against the performance of an obligation. In other words, collateral is an asset that the lender can take ownership of if the borrower fails to make his or her repayment requirements.
All loans are categorized as secured or unsecured. A credit card is an example of an unsecured loan because no collateral is involved. But with secured loans such as a home loan (mortgage), automobile loan or farm equipment loan, collateral is required. In these examples, the property being financed serves as the collateral.
However, in most secured loans other than mortgages and auto loans, the collateral is rarely the item being financed. According to Verlyn Gulley, Vice President of Consumer and Real Estate Loans with Arvest Bank, lenders prefer collateral that can be easily liquidated.
“Our standard collateral requirement on a small business or personal loan is an asset that has real market value and is not expected to significantly depreciate during the life of the loan,” Gulley said. “For loan collateral, we rarely accept items that may have historical, artistic or sentimental value. Let’s say someone is trying to put up his antique gun collection to secure a personal loan. While a gun expert may have appraised the collection at $5,000, it is not an asset that can be easily converted to cash. Therefore, its collateral value is minimal at best.”
Gulley said assets such as stocks, bonds, CDs (certificates of deposit), vehicles paid in full and even cash are lenders’ preferred form of collateral. While secured loans typically offer borrowers better rates than unsecured loans, failure to meet repayment obligations can cause severe consequences.
For example, if you become delinquent on an your automobile note or mortgage, the institution financing the property could eventually repossess your vehicle or foreclose on your home. The property would probably then be sold at auction (the law usually requires repossessed property to be sold in an open exchange). The proceeds from the sale would be applied to the remaining balance on the loan. However, if the proceeds are not enough to cover what you owe, then you would be responsible for paying the remaining balance. And if not paid in a timely manner, the debt will usually end up with a collection agency that will aggressively attempt to collect. In addition to losing your home or vehicle, your credit will be stained, and you could still be stuck with a payment on property you no longer own.
So, when you’re in the market for a secured or unsecured loan, make sure you have a plan to pay it back in full and on time. Also, visit with different lending institutions for the loan that fits your needs and won’t break your budget. Furthermore, don’t neglect the other two Cs of Credit (character and capacity), because establishing a positive credit history and keeping consistent employment are probably even more important to lenders than having valuable collateral.
By taking care of the “Three Cs of Credit,” you’ll be on your way to achieving that one goal of financial freedom.
Mary Catherine Harcourt is with Credit Counseling of Arkansas.
