What’s it: Collateral is a borrower’s asset pledged when taking out a loan. They agreed to turn it over to the lender when they defaulted on the loan. For lenders, it aims to secure loan repayments and reduce the impact of a default. Meanwhile, the borrower can get a larger principal, lower interest, or other relief with collateral.
Lenders such as banks take risks when they lend money, i.e., the borrower fails to pay its contractual obligations. Thus, they want collateral to reduce the risk. And, when borrowers fail to repay the loan, they expect to recover their finances by foreclosing and selling the collateral.
For instance, you use your house as collateral to get a bank loan. The bank will foreclose on your house when you fail to repay the loan.
If you have collateral, we say a loan is a secured loan. Otherwise, we call it an unsecured loan.
How does collateral work?
When creditors such as banks and debt securities investors lend money to borrowers, they run the risk of default, i.e., the borrower fails to repay the loan according to the contract. This risk can disrupt their finances, especially if the loan principal is large enough.
One way is to ask for collateral. The creditor will ask the borrower to pledge the assets owned. Thus, when borrowers fail to meet their obligations, they can foreclose and sell the assets to recover their finances.
Why should there be collateral?
Now, say you are taking out a secured loan from a bank. The bank has a claim on the assets you pledged as collateral. If you stop paying off at any time due to financial problems, the bank has the right to confiscate the asset.
For banks, these assets can reduce the risk they bear. They can confiscate it and sell it to recover the money lost in default. In other words, it is a hedge for the loans they provide.
On the other hand, the asset is an incentive for borrowers to continue making payments according to the contract. Otherwise, you can lose the asset.
In general, collateral is important to attract banks to lend. Banks usually prefer loans with collateral to those without. They see borrowers as having lower risk. Thus, they may be willing to lend money with a larger principal, lower interest, or longer term.
What are examples of collateral?
Some loans are built-in. For example, if you apply for a loan to buy a car, the bank will ask you to use the car as collateral. As long as you have not paid off, the car is not entirely yours because the bank can confiscate it at any time when you fail to pay the installments.
Another example is a mortgage. It is almost always a secured loan because it carries a high risk. So, when you borrow money to buy a house, you agree to use the house as collateral. When you fail to pay the installments, the bank will ask for your house and sell it.
Another example is in the capital market. Margin trading usually applies to collateral. In this case, the investor borrows money from a broker to buy a security on margin. To do so, the investor must have a balance in the broker’s account, which is used as collateral.
Borrowing from a broker allows investors to buy more securities with minimal capital. Thus, when the market is bullish, they can generate significant profits, higher than relying solely on their own capital.
But, when the market is bad, investors can lose the money they borrowed. Even if they lose, they must still fulfill their contractual obligations. They must raise the money somehow to repay their loan.
What are the pros and cons of collateralized loans?
Loans with collateral usually have a lower interest rate than loans without collateral. In other words, the borrower can get a loan at a lower cost. In addition, lenders often also provide lighter terms with longer terms and larger amounts. This is because secured loans are considered less risky than unsecured ones.
Meanwhile, for lenders, collateral reduces the risk they bear when handing over money. The more the collateral is equivalent to the principal of the loan, the lower the risk borne due to default. When borrowers fail to meet their contractual obligations, they can seize the collateralized assets and sell them to recover their finances.
Then, by pledging assets, it improves the credit profile. In fact, it provides credit opportunities for those who would not normally qualify for regular loans.
However, pledging assets also has a negative side. It has inherent risks. It may not be a problem when the borrower pays the loan according to the contract. But, if not, the borrower is likely to lose the collateralized asset.
Loans with collateral also bring up another negative side. It is only available to those with valuable assets to pledge as collateral. Thus, those with low incomes or fewer assets find it difficult to qualify.
Lastly, asset quality is another issue. For example, a newly purchased car has a high fair price when used as collateral. However, its value decreases over time as it is used. Thus, asset quality affects how much money a lender can recover. And therefore, it requires careful valuation.