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What Is A Collateral?

Collateral refers to a valuable asset used by a borrower to secure a loan from a bank or other financial institution.

Deeper Definition 

Collateral is an asset that a borrower offers to a lender as security for a loan. It has to be something of value that the lender can sell if the borrower defaults on the loan to recoup some or all their money. When a borrower takes a loan and secures it with collateral, lenders often offer a lower interest rate. On the other hand, loans taken without collateral attract high-interest rates.

Before granting a loan to a borrower, a lender would like to know whether the borrower can pay it back with interest after the agreed term. If a borrower cannot repay a loan, the lender loses their money. To avoid losing their money, a lender may demand that a borrower provide a valuable asset as security for the loan. Collateral assures a lender that even if a borrower fails to pay the loan. They cannot lose their money as they have the right to sell the asset to mitigate losses. On the other hand, it motivates a borrower to pay back not to forfeit their valuable.

Loans that require collateral are called “secured loans”. While loans that do not require collateral are called “unsecured loans”. In many cases, the kind of loan may determine what will serve as collateral. For instance, when the loan is a mortgage loan, the home serves as the collateral, and if it is an auto loan, the car becomes the collateral. Most financial institutions often demand that the collateral be equal to or greater than the loan amount.

Collateral Example

Vivian approaches a bank and requests a $200,000 loan to start a new business. The bank demands collateral from her to secure the loan before approval. After going through her assets, Vivian decides to use her house, whose market value is $350,000. The bank grants Vivian the loan and her proceeds to start the business. Unfortunately, things do not work according to plan, and the company crumbles. Since Vivian cannot pay the loan, the bank sells her house to recoup the money and give her what’s left from the proceeding.

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