Collateral refers to assets that has been pledge to a lender in order to secure a loan arrangement or credit facility.
When financial assets are used as collateral for a loan, they are often referred to as security.
For an individual, the assets can often be anything from real property, personal property, fixed deposits, stocks and shares, etc.
For companies, the assets pledged can be anything from inventory, vehicles, machinery, equipment, negotiable instruments, receivables, etc.
People and entities can often require financing for troubled times or for leveraged investments. And the bank is one of the first places they turn to for funds.
As unsecured loans and credit lines can be difficult to obtain approval for and expensive as they usually carry high interest rates, borrowers often choose secured lending when the option is available.
As these are secured loans, lenders would find it easier to approve them as they are confident of getting their money back even in the event of default. In that case, they can just repossess the assets and liquidate them to settle the debt.
Because of the lower risks involved with loans against collateral, they would also offer lower interest rates to borrowers.
A home equity loan is a good example of easy approvals and low mortgage rates.
How collateralized debt works
When collateral is used to secure a loan for example, the value of the asset being pledged is one of the key primary concerns of the lender.
This is because the value of the collateral or security can potentially determine how much money they can get back.
It would also be ridiculous to grant a borrower a loan of $500,000 when the value of the asset is just $250,000.
For a mortgage for example, a home valuation would be conducted to determine the value of the property in question. The loan approved will heavily depend on the property value. Once the home loan is approved by the bank and accepted by the homeowner, a lien or charge is placed on the property. Upon full repayment of the debt, the property is released from the mortgage lien or charge and becomes unencumbered.
Should loan repayment fall into delinquency and eventually go into default, then the lender would have the legal right to foreclose the property and sell it off, probably in an auction house to raise sales proceeds so as to pay off the outstanding debt.
Downside of secured loans
While secured loans come with great advantages such as less stringent credit assessment and better interest rates, the biggest disadvantage is that there is always a chance of the borrower losing the asset being pledged as collateral.
Putting the house up as collateral for example, inexplicably puts the borrower at risk of becoming homeless should he be unable to fully repay the loan.
At lease with hire purchases where companies pledge equipment for financing it’s purchase, the equipment is used to generate revenue. Which in turn creates the funds needed to continue servicing the debt.
Defaulting on an equipment loan would mean repossession of the equipment, which probably is not generating enough income anyway since it is unable to pay for itself.
So do put careful thought into the decision process when considering putting up collateral for different types of debt and financing.
