What is Collateral?
Collateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower default in his payments. In such an event, the collateral becomes the property of the lender to compensate for the unreturned borrowed money.
For example, if a person wants to take out a loan from the bank, he may use his car or the title of a piece of property as collateral. If he fails to repay the loan, the collateral may be seized by the bank, based on the two parties’ agreement. If the borrower has finished paying back his loan, then the collateral is returned to his possession.
Types of Collateral
In order to be able to take out a loan successfully, every business owner or individual should know the different types of collateral that can be used when borrowing.
1. Real estate
The most common type of collateral used by borrowers is real estate, such as one’s home or a parcel of land. Such properties come with a high value and low depreciation. However, it can also be risky because if the property is sequestered due to a default, it cannot any longer be taken back.
2. Cash secured loan
Cash is another common type of collateral because it works very simply. An individual can take a loan from the bank where he maintains active accounts, and in the event of a default, the bank can liquidate his accounts in order to recoup the borrowed money.
3. Inventory financing
This involves inventory that serves as the collateral for a loan. Should a default happen, the items listed in the inventory can be sold by the lender to recoup its loss.
4. Invoice collateral
Invoices are one of the types of collateral used by small businesses, wherein invoices to customers of the business that are still outstanding – unpaid – are used as collateral.
5. Blanket liens
This involves the use of a lien, which is a legal claim allowing a lender to dispose of the assets of a business that is in default on a loan.
Borrowing without Collateral
Not all loans require collateral, especially if the borrower doesn’t have any property to offer. In such a case, there are several ways to borrow money, including:
1. Unsecured loans
From the name itself, unsecured loans don’t give the lender any form of assurance or protection that the money will be returned. However, they usually involve relatively smaller amounts than what might be loaned against collateral. Examples of unsecured loans include credit card debts.
2. Online loans
With the advancement of technology, there are many more ways to get a loan. In fact, people can now obtain online loans that don’t require collateral and are often approved quickly. After filling out an application form, the lender will let the applicant know if he or she is approved, how much the loan amount is, the interest rate, and how the payments are supposed to be made.
3. Using a co-maker or co-signer
These types of loans don’t require property for collateral. Instead, another individual besides the borrower co-signs the loan. If the borrower defaults, the co-signer is obliged to pay the loan. Lenders prefer co-signers with a higher credit rating than the borrower. A co-signed loan is often one way an individual without established credit can begin to establish a credit history.
Collateral vs. Security
Collateral and security are two terms that often confuse people who think the terms are completely synonymous. In fact, the two concepts are different. The differences are explained below:
- Collateral is any property or asset that is given by a borrower to a lender in order to secure a loan. It serves as an assurance that the lender will not suffer a significant loss. Securities, on the other hand, refer specifically to financial assets (such as stock shares) that are used as collateral. Using securities when taking out a loan is called securities-based lending.
- Collateral can be the title of a parcel of land, a car, or a house and lot, while securities are things such as bonds, futures, swaps, options, and stocks.
- Collateral, or at least the ownership title to it, stays with the lender throughout the time the borrower is paying the loan. Securities, on the other hand, allow the borrower to benefit from both the loan and the securities portfolio even while the loan is still being paid back because the securities portfolio remains under the borrower’s control. However, the lender assumes a greater risk because the value of the securities may fluctuate substantially.
Thank you for reading CFI’s explanation of collateral. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful: