A collateral is an asset that the buyer gives to the lender as security for a loan. It can be in the form of real estate, cars, bonds, and many other assets. It acts as a form of protection to the lender if the borrower defaults. It is used as a protection against potential loss should the borrower default in his payments while obtaining a loan. During such events, the collateral becomes the property of the lender used for compensating the unreturned borrowed money, to cover the losses.
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Types of collateral:
The following are the types of collateral that can be used while borrowing:
- Real estate: It is the most common type of collateral used by borrowers, examples are one’s home or a parcel of land. Such properties have a high value and low depreciation. However, it is also sometimes because if the property is sequestered due to a default, it can no longer be taken back.
- Cash secured loan: This is another common type because its functioning is very simple. An individual can take a loan from the bank where he/she maintains active accounts and transactions, and in case of a default, the bank can liquidate his accounts for recouping the borrowed money.
- Inventory Financing: This involves inventory that acts as the collateral for a loan. If a default takes place the items listed in the inventory can be sold by the lender of the loan to recoup its loss.
- Invoice collateral: This type of collateral is usually used by small businesses, wherein outstanding and unpaid invoices to customers of the business are used as collateral.
- Blanket liens: This involves the use of a lien, which is a legal claim which allows the lender to dispose of the assets of a business that is in default on a loan.
Collateral lending vs Security lending:
- A collateral is an asset that the buyer gives to the lender as security for a loan. It acts as a protection to the lender. Securities are financial assets like stocks and shares that are used as collateral.
- Collateral can be a piece of land, a car, a home, etc while securities refer to financial assets like bonds, stocks, etc.
- The ownership title of collateral is with the lender until the payment of the loan. Whereas, securities remain under the borrower’s control even while paying back the loan. Due to the fluctuating value of the security, the lender assumes the greater risk.
Examples of collateral loans:
- Residential mortgages: A mortgage is a loan where the home is used as collateral. If the homeowner is unable to pay the mortgage for 120 days, the legal proceedings can be started by the loan servicer where the lender can eventually take possession of the house via foreclosure.
- Home equity loans: Here too, the home can be used as collateral on a second mortgage or HELOC. The amount of the loan is lesser than the available equity. For example, if a home is valued at $300,000 and $170,000 remains on the primary mortgage, a second mortgage will be available only for $130,000.
- Margin Trading: An investor can borrow money from a broker to buy shares and use the balance in his brokerage account as collateral. The account can be used by the broker to recover the losses if the investor is unable to make payments.
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Collateral is the basis of asset-based secured lending. This helps to reduce the risk for lenders. It can also help borrowers qualify for loans that have lower interest rates.
Abha Shetty: Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.
Mahek Medh: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.