Collateral

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Definition of Collateral:

Collateral is an asset that is pledged to secure a loan.

Detailed Explanation:

Bankers often require collateral when taking out a loan to minimize their risk. A lender can legally force the sale of the collateral to settle the loan when borrowers neglect to make their payments on time. Understandably, bankers believe borrowers are more likely to repay a loan if they risk losing the secured asset. On the other hand, an unsecured loan is a loan without collateral. Unsecured loans usually come with higher interest rates because they pose a greater risk of non-payment.

Theoretically, any asset can be collateral. The most commonly used assets include real estate, vehicles, equipment, or securities such as stocks. For example, suppose James wants to buy a $200,000 home. He puts $40,000 of his savings towards a down payment and borrows the remaining $160,000 using a mortgage. A mortgage is a loan that uses real estate as collateral. The bank places a lien on the property, which means that James can only sell his home if he pays off the mortgage. The bank is protected by having collateral valued at $200,000 to cover a $160,000 loan. If James fails to make timely payments, the bank can foreclose on the property, allowing them to sell James’s home to pay off the loan. If James chooses to move and sell his home, the bank would be safeguarded by its lien, and the sale proceeds would be used to pay off the loan balance.

Usually, the purchased asset is collateral. For instance, when a buyer uses a car loan to buy a vehicle, the vehicle also serves as collateral. However, this is not mandatory. A homeowner may use a home equity loan, which is a mortgage, to consolidate bills or make other purchases because borrowers want to benefit from a lower interest rate and better terms than an unsecured loan. Margin loans, secured by stock, are typically used to buy other shares. However, the borrower can use them for any purpose. The brokerage firm may issue a margin call and demand the sale of the collateral if the value of the stock used as collateral drops significantly.

A credit card is the most common type of unsecured loan, which explains why it usually carries a higher interest rate than other less risky loans. The lender cannot compel the borrower to sell an asset to pay off the credit card. Instead, the lender may report late payments to a credit bureau, negatively impacting the borrower’s credit rating and ability to borrow money. As a result, the borrower may struggle to find a willing lender and, if successful, will likely face a higher interest rate.

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