DEFINITION: In the realm of finance, the term “collateral” refers to a valuable asset that a borrower offers as assurance for a loan.
For example, when a prospective homeowner secures a mortgage, the property itself functions as the collateral underpinning the loan. This means that if the homeowner defaults on his monthly payments, then the bank will foreclose on the loan and repossess the home.
Similarly, in the case of a car loan, the automobile being financed assumes the role of collateral.
In the case of a business procuring a bank loan, the firm may offer substantial assets like equipment or real estate as collateral against the loan. In case of default, the lender retains may seize the collateral and sell it to recuperate any losses it has incurred.
Even general personal loans may be “collateralized,” meaning it may be backed by some type of asset. For example, secured credit cards require a cash deposit to serve as collateral.
ETYMOLOGY: The English word “collateral” is attested from the fourteenth century.
The noun “collateral” derives, via Middle English and Anglo-French, from the Medieval Latin adjective collateralis, collaterale, which, in turn, derives from the classical Latin preposition cum-, meaning “with,” and the noun latus, lateris, meaning “flank” or “side.”
USAGE: When a prospective borrower applies for a loan, the bank seeks assurance that the borrower will be able to pay it back. This is the fundamental reason why lenders require borrowers to provide them with a form of protection: namely, collateral.
Collateral serves to diminish a lender’s risk by incentivizing the borrower to adhere to his or her financial commitment. In the case of a home loan (known as a “mortgage”), the borrower is motivated to make his monthly payments in a timely fashion by the prospect of losing the home—which serves as collateral for a mortgage—if he defaults.
Loans backed by collateral generally come with significantly reduced interest rates compared to unsecured loans.
A lender’s entitlement to a borrower’s collateral may be referred to as a “lien,” signifying the lender’s legal entitlement against the asset for the purpose of settling a debt.
If the borrower defaults and the lender takes possession of the collateral in order to sell it, but the price obtained for the collateral is not sufficient to compensate the lender for its losses, then the lender may initiate legal proceedings against the borrower in order to recover its outstanding losses.
The type of asset accepted as collateral is usually determined by the type of loan in question. For example, in the case of a mortgage, the loan is most often secured by the residence being financed.
Analogously, in the case of an automobile loan, the car being financed usually serves as collateral.
In general, lenders accept as collateral such assets as fully paid-off cars and boats, expensive luxury items such as furs and jewelry, whole-life insurance policies, savings-deposit accounts, and investment accounts. However, in most cases retirement accounts are not acceptable.
Another possibility for borrowing is the secured personal loan. This is a type of loan in which the borrower pledges a valuable possession as collateral. The worth of the pledged item should at least equal the amount of the loan.
When thinking about applying for a secured personal loan, you should choose a financial institution with which you already have a connection, especially if your collateral involves your savings account.
Having an existing relationship with the lender increases the likelihood of your loan application’s being approved. It will also improve your chances of obtaining a favorable interest rate.