A collateral transaction requires some type of asset to be provided by a borrower to a lender, usually in exchange for a loan. If the person borrowing the funds does not repay based on the terms of the agreement, the lender can seize the item given as collateral.

What Is Collateral?

Collateral is any type of asset that a borrower pledges to a lender in order to receive a loan. If the borrower fails to make the payments as promised, the lender can take the collateral as a way to recoup the loss. Collateral provides security to the lender in case the borrower fails to meet the terms of repayment. One of the benefits of a collateral transaction is that the borrower can typically get a lower interest rate than they would with an unsecured loan or transaction.

The claim on the collateral held by the lender is referred to as a "lien." What qualifies as collateral can vary, depending on the type of the loan. For example, in an auto loan, the vehicle might be used as collateral, while in a mortgage loan, the property is used as collateral. With a personal loan, there is more flexibility regarding what qualifies as collateral. In order for a loan to be secure, the value of what is provided as collateral must exceed or equal the remaining amount of the loan.

Collateral serves as security in a loan, so the lower risk to the lender often comes with a lower interest rate for the borrower. A secured loan has less risk for the lender, since maintaining the collateral is a good reason to meet the terms of the loan and continue to make payments. The lender can repossess the collateral to cover what is remaining on the loan if the borrower fails to repay according to the terms outlined in the agreement. A mortgage loan's collateral is the house or property bought with the funds loaned to the borrower.

If the borrower fails to pay back the debt, the lender can go through the process of foreclosure, which allows them to take possession of the property. After the property is taken by the lender, they will sell the property to recoup the funds lost on the loan.

The home or property can also serve as the collateral on a home equity line of credit (HELOC) or a second mortgage. In this case, the amount loaned to the borrower cannot exceed the amount of equity available in the house. For example, if the primary mortgage amount outstanding on a property is $225,000 and the home is valued at $300,000, a lender will probably only provide a HELOC or second mortgage for $75,000 or less.

Collateral in Margin Trading

When participating in margin trading, the brokerage account's securities serve as collateral in the event of a margin call. In this case, the collateral is similar to the security provided to the lender when collateral is given in exchange for a loan. The securities' value offers assurance that the lending institution could recover the funds if needed.

Collateral and Credit Cards

When you pay for something with a credit card, the issuer of the card doesn't receive any collateral in exchange for the purchase. Since the risk is higher for lenders, credit cards tend to have much higher interest rates than auto or mortgage loans.

For example, let's say you wish to borrow $50,000 to start a company. Even if your credit rating is very high, a lender may still be hesitant to issue the loan because it could lose all of that money if you fail to repay the debt. In order to mitigate that risk, you would need to provide collateral items that are worth the value of the loan in exchange for the debt. This could include:

  • Homes or property
  • Cash
  • Financial instruments
  • Art
  • Jewelry
  • Other items

Collateral in Business

A mortgage loan is one of the most common types of collateral transactions because the house serves as the collateral. However, many other types of loans require the borrower to provide collateral. For example, a margin loan will nearly always require the borrower to provide collateral, which is usually the securities that are associated with this type of loan. Some business owners also elect to provide the receivables from the company as collateral.

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