Understanding Different Real Estate Collateral Types
Making a real estate investment requires a lot of commitment. Understanding the legalities and fundamentals of the industry takes time and patience. Real estate collateral loans are a big piece of the puzzle - it’s one of the hoops that every individual and business, large and small, will have to jump through to secure a loan and purchase property.
If you’re thinking about investing in real estate - whether it be on the residential or the commercial side - you should have a firm understanding of the types of collateral that may be involved. Protecting yourself is key if you hope to make a sound investment that pays you back. Learn everything there is to know about real estate collateral here.
What is Real Estate Collateral?
Real estate collateral is any personal property used to guarantee a mortgage loan. Typically a property used in real estate collateral loans could include buildings, factories, warehouses or even shopping malls - all of which are generally considered safer investments that have value and typically do not depreciate quickly.
Collateral property is placed on hold in an arrangement so that the owner of the mortgage (the lender or investor) could sell and recoup their investment should the borrower ever default on the loan.
Types of Real Estate Collateral
There are multiple collateral real estate types. The situation a borrower is in and the mortgage they’re seeking will determine which form of real estate collateral is the most appropriate for their funding needs. Understanding that there are multiple real estate collateral types is essential if you plan on investing in real estate.
Mortgage Note on Property
The first type of real estate collateral to understand is a mortgage note on property (which shouldn’t be confused with a mortgage loan). Mortgage notes are the document a buyer/borrower signs at the closing to secure a mortgage. It holds all the terms of the loan.
A mortgage note signifies to an investor that there is a mortgage in the first-lien position on the property in question. This means that in the event of a default, the property the note is associated with would be liquidated, more easily offsetting any of the investor’s loss.
Assignment of Rents
Assignment of rents (also known as Assignment of Leases, Rents and Profits) is an alternative type of real estate collateral used to secure real estate funds. This type of collateral works as an arrangement that guarantees an investor the rights to income made through the lease or rental of the associated property if the borrower ever defaults on the loan. Note, this arrangement doesn’t mean that the investor would have the right to collect rental income outright.
An example of when and how an assignment of rents could work is: if a borrower is purchasing a strip mall where shopfronts have tenants actively paying rent, the investor would have the right to collect that rent in the event of a default on the loan. This form of collateral can be beneficial if you’re interested in investing in commercial property, though it’s not as common for residential.
Security Interest
In this form of real estate collateral type, personal belongings, instead of other property, can be used to secure real estate. If the borrower defaults on the loan terms, those assets can be seized. Should this happen, rather than seizing other collateral properties or foreclosing on a property, a lender may instead repossess furnishings or office equipment. Essentially, whatever items or assets of value that were put up for collateral on the property would be at risk.
Likely, the lender would simply sell repossessed assets to pay off the defaulted loan. Benefits of using security interest to secure a loan include a reduced risk of default as the borrower doesn’t want to lose his or her personal assets.
Personal Guarantee
The final type of real estate collateral you can consider is taking a personal guarantee. This option is typically only available for borrowers who have the ability to use their credit, worth and name recognition to take out a loan without having to put down physical collateral because the lender does not fear an inability to repay the loan.
A personal guarantee is a legally binding promise to repay a loan. It’s very similar to the process of buying something “on credit.” Generally, borrowers who are able to use a personal guarantee as collateral must have plenty of personal wealth, secured real estate funds or access to other forms of collateral to back the loan, though physical collateral isn’t asked for due to their experience or wealth.