Collateral

Key Takeaways

• Collateral is property pledged to secure a debt, giving the lender a claim against that specific property if the borrower defaults.
• Pledging real property transfers no possession. The borrower keeps title and occupancy while the lender holds a recorded lien.
• The promissory note carries the promise to repay; the security instrument pledges the collateral, and Washington's usual security instrument is the deed of trust (RCW 61.24.020).
• After a trustee's sale in Washington no deficiency judgment may be obtained against the borrower on a residential loan, so the collateral is where the lender's recovery ends (RCW 61.24.100).

What It Means

Collateral is property a borrower pledges so that a lender will make the loan. If payments stop, the lender can force a sale of the pledged property and take the proceeds up to what it is owed. That pledge is what separates secured debt from Unsecured Debt. An unsecured lender has only the borrower's promise to fall back on, while a secured lender has a claim against a specific asset from the day the loan closes. Our rundown of common loan types sorts the secured from the unsecured.

Pledging real property does not hand the property over. The borrower keeps title, lives in the house or rents it out, and improves it, while the lender holds a lien recorded against it. The formal name for pledging property without giving up possession is hypothecation. Ownership and use stay with the borrower, and only the right to force a sale moves to the lender.

Two documents do two different jobs at closing. The Promissory Note carries the promise to repay, with the amount, the rate and the term. The Security Instrument pledges the collateral and creates the lien. A note signed on its own creates a debt with nothing behind it, which is why the second document gets recorded.

How It Works in Washington

In Washington, real property is pledged as collateral through a Deed Of Trust rather than a mortgage. RCW 61.24.020 provides that a deed conveying real property to a trustee in trust to secure the performance of an obligation of the grantor or another to the beneficiary may be foreclosed by trustee's sale, and it directs the county auditor to record that deed as a mortgage, listing the grantor as mortgagor and the trustee and beneficiary as mortgagee. The same section bars any one person or entity from serving as both trustee and beneficiary, with a narrow exception for federal agencies, so a third party always holds the power of sale.

The consequence for borrowers is substantial. RCW 61.24.100 provides that a deficiency judgment shall not be obtained on the obligations secured by a deed of trust against any borrower, grantor or guarantor after a trustee's sale. The exceptions reach certain commercial loans and specifically exclude property the borrower occupies as a principal residence as of the date of the trustee's sale. If the collateral sells for less than the debt on a residential loan, the lender absorbs the shortfall. In Washington the collateral is not simply the lender's first remedy after a nonjudicial foreclosure. It is effectively the only one, which is why appraisal quality and the borrower's down payment matter so much to the lender at the outset.

Example

Ravi buys a Yakima house for $340,000, puts $68,000 down and borrows $272,000. At closing he signs two documents. The promissory note is his personal promise to repay $272,000 on stated terms. The deed of trust conveys the house to a trustee to secure that promise, and it is recorded with the Yakima County auditor, which is what makes the house the collateral. Ravi moves in and holds title the entire time.

Three years later he loses his job and stops paying with $258,000 still owed. The beneficiary instructs the trustee to proceed to a trustee's sale and the house brings $240,000. Those proceeds cover $240,000 of the $258,000 balance and leave an $18,000 shortfall. Under RCW 61.24.100 the lender cannot obtain a deficiency judgment against Ravi for that $18,000 after the trustee's sale. The lender took the collateral, and with the collateral the recovery ends.

Common Mistakes and Exam Traps

• Collateral does not change hands when the loan is made. The borrower keeps title and possession, and the lender holds a lien against the property.
• The promissory note does not pledge collateral. The security instrument does, and in Washington that is normally the deed of trust.
• A deed of trust involves three parties, the borrower as grantor, the lender as beneficiary and a neutral trustee holding the power of sale, while a mortgage involves two.
• Collateral is not limited to the property being purchased. Any property the borrower pledges can serve, which is what a blanket mortgage covering several parcels does.