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What is Collateral and How Does It Play a Role In My Mortgage?

Collateral is a property or other asset that a borrower offers as a way for a lender to secure the loan.

For a mortgage, the collateral is often the house purchased with the funds from the mortgage. If the borrower stops making loan payments, the lender can take hold of the items or house designated as collateral, to recover its losses on their loan. Since collateral offers some security to the lender should the borrower fail to pay back the loan, loans that are secured by collateral typically have lower interest rates than unsecured loans.

For a loan to be considered secure, the value of the collateral must meet or exceed the amount remaining on loan.

Benefits and disadvantages of using collateral to secure a loan

Pros

  • Increases chance of approval. Securing your loan justifies the risk to the lender and can increase your chances of approval. Even if you don’t have a perfect credit score, you have something that is valuable enough to pay back the amount of the loan if you find yourself in a hard situation.
  • Lower interest rates. When you have an excellent credit score, you’ll often get premium rates from lenders. While you may not have the best score, providing security could get you a better interest rate, as a result of the lowered risk to the lender.
  • More wiggle room.It’s always good to have room to negotiate. With increased chances of approval, lower interest rates and longer terms, you can often get terms that fit your budget. Cutting down the length of the loan might give you a lower overall cost, while extending it can afford you smaller monthly payments.

Cons

  • Repossession. Defaulting on a secured loan means losing whatever that security is. Expensive family heirlooms, your car or even your home can be taken if you designated them as collateral to the lender. Even though most people plan on paying off their loans, life happens. Losing the collateral you offered could potentially end up making a bad situation worse.
  • Overspending. Security generally affords you a little more leeway. Be careful though, because taking out more money than you need can mean additional interest payments. If you’re tempted to use the money for a purchase with no return (ROI), you may want to look at your entire financial picture first.
  • Longer term. A longer repayment period can sound like a great advantage if you want to lower your monthly payments. However, it also means paying more interest over the life of the loan. A higher overall cost to your loan may not be worth the extra wiggle room from month to month.

Because the home becomes owned by the lender if you can’t make your mortgage payments, the underwriter needs to know exactly what the worth of the home being purchased is – through a process called an appraisal.

An appraisal is an unbiased professional opinion of a home’s value. In the sale or purchase of a home, an appraisal is used to determine whether the home’s contract price is appropriate given the home’s condition, location, and features. In a refinance, it assures the lender that it isn’t handing the borrower more money than the home is worth.

The lender will usually order the appraisal, but Federal regulations state that the appraiser must be impartial and have no direct or indirect interest in the transaction.

How Does the Appraiser Determine the Property Value?

The appraisal will consider many factors, including recent sales of comparable and nearby homes, the home’s location, its condition, and even potential rental income. To determine the value, the appraiser compares the square footage, appearance, amenities and condition of the property against comparable homes. The report must include a street map showing the appraised property and comparable sales used; an exterior building sketch; an explanation of how the square footage was calculated; photographs of the home’s front, back and street scene; front exterior photographs of each comparable property used; and any other information, such as market sales data, public land records and public tax records, that is used to determine the property’s fair market value.

It usually costs between $450-$600 for an appraisal, depending on your property type and location. More expensive homes or homes that have more than 1 unit, cost higher to get appraised. The appraisal process usually takes anywhere between 3-10 business days. The report usually goes to the mortgage lender, but you have a right to receive a copy of the appraisal report – you must request it though.

If the appraisal is at or above the contract price, the transaction proceeds as planned. If the appraisal is below the contract price, it can delay or ruin the transaction, as the borrower will only be approved for a loan at the lower amount.

As the buyer, you have an advantage. A low appraisal can serve as a negotiating tool to convince the seller to lower the price, as the lender won’t lend you or any other prospective buyer more than the home is worth.

There are several ways for the transaction to still happen if the property appraises for less and the loan amount is reduced. If you wrote your offer contract to include a clause requiring the property to be valued at the selling price or higher, you can:

  • Negotiate with the seller to reduce the selling price.
  • Put more money down to cover the difference between appraised value and the selling price.
  • Walk away from the deal.
  • Dispute the appraisal: find out what comparable sales were used and ask your realtor if they are suitable – your realtor will likely be more familiar with the area than the appraiser and can find additional comparable homes to validate a higher valuation.

Tips:

  • Health and safety: In determining the condition of the home, lenders will want to know whether the home is safe and structurally sound. They do not, however, require a termite or home inspection, but these are strongly recommended to protect yourself and your own investment.
  • Request a copy of your appraisal from the lender.

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