Collateral

What is Collateral?

The term refers to that asset that a lender accepts in the form of security for a loan; thus, acting as a protection for the lender. Collateral may be in the form of a Real Estate or any other asset, based on the loan’s purpose.

This way, even if the borrower turns defaulter, the lender has an opportunity to seize the collateral item and sell the same to recoup losses.

Way of Working: Collateral Explained

Before issuing the loan, the lender wants to reassure that you are capable of paying it. That is the reason why they ask for security in return. This acts as collateral that decreases the risk for lenders and helps them make sure that you keep up with your Obligation.

Although the lender can sell the collateral to get a part of the loan, however, if something remains, he can always go with the legal option to recoup the remaining amount. Considering that collateral comes in a variety of forms, it is generally related to the loan nature.

For instance, if you are taking a mortgage, you would have to put your home as collateral. Or, if you wish to have a car loan, then you would have to put the vehicle as security. And, if there are any personal, nonspecific loans, they can be collateralized by other assets. Moreover, if you secure your loan with collateral, you can get a substantially lower interest.

Collateral for a Loan: Example

Suppose you have taken a collateral loan on property in the form of a mortgage. Now, if you are unable to repay the loan, the lender can possess your home via foreclosure. This defaulting will compel you to transfer the property in the name of the lender.

A collateral example can also be understood from the fact that collateralized loans are also regarded as an aspect in margin trading. Here, an investor takes money from a broker to purchase shares with the available balance in the brokerage account of the investor, which acts as a collateral.

Thus, the loan increases the share numbers that an investor can purchase; hence, multiplying the potential profits in case the value of shares increases. However, in such a scenario, risks also get multiplied.

In case the share’s value decreases, the broker will demand the difference payment. In this scenario, the account will serve as the collateral if the loss cannot be recovered.