What Is Collateral?
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The Purpose of Collateral
In a lender-borrower relationship, “collateral” is an asset used by the lender to secure a loan. When a lender extends financing to a borrower, and the borrower fails to pay back the loan or comply with the other terms in the loan agreement, the lender is at least partially protected by their ability to take possession of the collateralized assets and liquidate them in an effort to recoup some (or all) of their losses.
In other words, collateral serves as protection for a lender. Additionally, if there is a shortfall after a lender seizes the collateral and liquidates it, the lender could sue the borrower for the difference.
In many cases, the value of the collateralized asset is not sufficient the make the lender whole in the event of default. This is part of the importance of understanding the Loan-to-Value (LTV) Ratio in conjunction with understanding the value of the asset (often through valuation reports like an appraisal).
The LTV helps the lender assess how large the loan amount should be relative to the value of the asset being financed. It also plays a role in determining how much equity the borrower should contribute to the financed asset as a down payment and whether additional collateral should be hypothecated.
Collateral is also one of the 5 C’s of Credit, which is used by loan underwriters to measure the inherent risks associated with larger commercial loans.
Why Collateral is Important
Collateral serves as a type of guarantee that the lender’s funds can be fully recovered in some way, shape, or form. Even if the borrower fails to return all of the borrowed money in the form of payments, the lender will have the fallback option of recouping their money by taking possession of the collateralized assets in the event of a default.
Since collateralized assets give lenders this kind of added assurance, it can also serve borrowers by allowing them to obtain a better interest rate on their loan in some cases, since it arguably minimizes their credit risk in the eyes of the lender.
Collateral generally makes it easier for a borrower to obtain a loan because the collateralized asset(s) provides an additional layer of protection for the lender in the event of a default (assuming the borrower also has a decent credit score and debt-to-income ratio, along with the other 5 Cs of Credit). If the borrower stops paying, the lender has a better chance to make themselves whole since it can take possession of the borrower’s collateral and liquidate it for cash.
Loans that do not use collateral
Not all loans require collateral. For example, money borrowed through the use of a credit card is an “unsecured” line of credit and not collateralized by any specific asset.
Since there is no collateral to liquidate if the borrower defaults on an unsecured loan, lenders need another method to minimize their risk. To minimize risk on an unsecured loan, lenders typically charge borrowers a significantly higher interest rate for the loan and/or the payback terms will be more restrictive since the lender can rely only on the borrower’s creditworthiness.