What is Collateral?

Collateral is an asset or piece of property that a borrower pledges to a lender as a form of security for a loan or line of credit. This can include tangible items such as real estate, personal property like cars, or intangible guarantees like stocks, insurance policies or the rights to future revenues from a business venture. Collateral can also include other investments, such as checking, savings and certificate of deposit (CD) accounts.

When a borrower signs a promissory note to take out a loan, the collateral gives the lender the legal right to seize the asset if the borrower defaults on the loan or line of credit. As a result, borrowers are required to make all payments according to the terms of the agreement in order to protect their collateral. If a borrower fails to make the payments, the lender can sell the collateral and keep the proceeds to cover the debt.

The Benefits of Collateral

The primary benefit of collateral is to give lenders a sense of security by providing a source of repayment in the event a borrower is unable to repay their loan. Lenders will generally lend more money if it is backed by collateral because there is less risk of default. Borrowers also benefit from collateral since it can help them secure more favorable interest rates and terms.

In addition, the use of collateral can help borrowers access more affordable financing when they don’t have a high credit score or a long credit history. This is because lenders view collateral as an additional source of repayment, which can help them extend lending options to individuals or businesses that wouldn’t typically be approved for a loan.

Types of Collateral

Collateral can come in many forms, including cash, real estate, personal property, stocks and bonds, life insurance policies and even receivables from customers. The type of collateral required for a specific loan or line of credit will depend on the lender and the type of loan being requested.

For example, most home loans are backed by real estate as collateral while car loans are typically collateralized by the car itself. Business loans are often secured with a variety of assets, including inventory, accounts receivable, equipment and real estate.

Ultimately, collateral helps lenders reduce the risk of default by providing them with a source of repayment if the borrower is unable to repay the loan or line of credit. This can provide borrowers access to more affordable financing, which can be beneficial for both parties.