1. What is Collateral?
Collateral is property (for example, accounts receivable, inventory) that the borrower offers to the lender in order to secure repayment of a loan. Collateral can also be personal property that lenders seize when borrowers default on loans.
2. Types of collateral?
There are two types of collateral:
- The first is called “specific” or “chattel” collateral and covers personal property, such as inventory. Specific collateral is usually the most valuable type of asset provided to secure a loan transaction (although it can be difficult for lenders to collect on specific collateral).
- The second type of collateral is “general” or “real” collateral. It’s the land, buildings and other real property used to secure a loan transaction.
3. Uses for collateral?
There are two main uses for collateral in a loan transaction:
The first is to secure repayment of the loan from the borrower. In other words, if you borrow money and use your car as collateral, you promise to repay the debt and give your creditor rights to your car in case you default on your loan.
Second, if you default on your loan, the creditor has the right to sell the collateral to recoup any losses they incur as a result of lending money to you. So if you borrow $10,000 and give your creditor your car, he or she is entitled (if you default) to take possession of your car and sell it for however much he or she can get for it.
4. How does a lender obtain collateral?
Lenders obtain collateral in two ways:
The first is by requiring you to pledge collateral when you borrow money from the lender. In other words, if you borrow $20,000 from your bank and sign a promissory note that specifies that you are borrowing money from the bank and that you pledge your boat as collateral, then the bank may be able to take possession of your boat if you should default.
The second way a lender obtains collateral is by purchasing it after the loan transaction documents have been signed but before the borrower has defaulted on the loan.
5. Advantages of Collateral?
There are several advantages to using collateral:
First of all, by pledging collateral you are giving the creditor valuable security that protects him or her from losing money in case you default on your loan. Also, if you wish to borrow more money, later on, it is likely that the creditor will require you to pledge collateral as part of the new loan.
6. Disadvantages of Collateral?
The disadvantages of pledging collateral include the following:
First of all, if you fail to repay your loan when it comes due, then the creditor has the right to sell the collateral in order to recoup any money he or she lost as a result of making such a loan. So if you borrow $10,000 and sign a promissory note that specifies that you will repay the loan and pledge your car as collateral, then if you default on the loan your creditor can foreclose against your car.
Second, pledging collateral decreases a borrower’s bargaining power because he or she has less “leverage” in dealing with creditors. In other words, if you need money from a bank and you have a house worth $50,000 that could be sold to help repay the loan, then you can use your house as leverage to try to obtain a lower interest rate on the loan. But if you sign a promissory note pledging your house as collateral for the loan, then the bank is likely to give you a higher interest rate and you will be less likely to obtain a lower interest rate.
Third, if you do not repay your loan and the bank forecloses on your house then you will have to move out of the house and lose any equity that may have been in it (if you must sell the house for less than what you owe on the loan).
