What Is Collateral?
Collateral is property or an asset that a borrower pledges to a lender as security for a loan. In the event that the borrower is not able to repay the loan, the lender can seize the collateral to recover the value of the loan. This reduces the risk for the lender while it enables the borrower to obtain a loan easily, typically at lower interest.
How Collateral Works?
- Loan Agreement: Both the lender and borrower agree to the loan terms, including the collateral requirement.
- Pledging Collateral: The borrower pledges an asset (e.g., property, car, shares) as collateral.
- Loan Disbursement: After approval, the lender disburses the loan amount to the borrower.
- Repayment Obligation: The borrower must repay the loan according to the agreed terms.
- Collateral Seizure: On default by the borrower, the lender takes away the collateral and sells it in order to recover the loss.
Types Of Collateral
- Property: Buildings, houses and lands are used as collateral for residential property and commercial loans.
- Vehicles: Motor cars, trucks, or other motor vehicles are some of the vehicles that might be used as collateral for automobile loans.
- Cash and savings: Savings accounts or fixed deposits, are provided as security against secured loans.
- Investments: Stocks, bonds, or mutual funds may be used as collateral for margin loans.
- Inventory: Stock or merchandise may be used as collateral for business loans.
- Machinery and Equipment: Machinery and equipment are utilised as collateral to provide finance for business.
- Valuables and Precious Metals: Gold, jewellery, or other precious valuables may be used as collateral.
Advantages Of Collateral
- Lower Interest Rates: Since collateral reduces the risk for the lender, secured loans are lower interest-charged.
- Larger Loans: Borrowers borrow larger loans by providing valuable collateral.
- Quick Loan Approval: The banks prefer to sanction loans if collateral is provided.
- Adjustable Repayment Terms: More favorable repayment terms would be possible for borrowers because lenders are placed at lower risks.
- Builds Credit History: On-time payment on a secured loan creates credit history, and future lending is made easier.
Key takeaways
Collateral is a piece of property the borrower commits to providing as collateral. This is a loan that lowers the lender's risk and can lead to lower interest charges and loan limits. Some examples are property, vehicles, money, investments, and assets of a business. If the borrower does not repay the loan, the lender can seize the collateral as payment for the loss. Collateral-backed loans provide smooth approval and a streamlined payment schedule and aid in building a credit history.
