Written by Team 365 finance
Collateral is a pledge of a specific asset made by a borrower to their lender. In order to borrow money, the borrower might need to pledge a specific piece of real estate, equipment or another asset to the lender as protection. This asset is referred to as collateral.
By providing an asset as collateral, a borrower can reduce the risk for any lenders that provide financing. If the borrower defaults on the loan, the lender can seize the asset and sell it in order to recoup some or all of the loan principal and interest.
Not all lenders require collateral. If a business or individual has good credit, they might be able to borrow a significant amount of money without offering collateral to a lender. Offering an asset as collateral can often help a borrower access lower interest rates and less costly financing.
Below, we’ve explained what collateral is and how it works as part of the financing process for businesses. We’ve also looked at some of the advantages and disadvantages of collateral for borrowers and lenders alike.
What is Collateral?
Collateral is any asset that a lender receives the right to seize in the event of non-payment of a loan. Common types of collateral include real estate (by far the most popular form of collateral for most individual loans), product inventory, equipment and other assets.
In some cases, borrowers might also offer cash as a type of collateral. A loan that’s secured by cash, typically in the form of a certificate of deposit or savings account balance, is known as a cash secured loan.
Loans can also be secured using valuable assets such as jewelry, vehicles and other personal possessions. While cash is almost always accepted as a type of collateral, most lenders do not accept funds stored in retirement accounts.
Not all loans require collateral. Some loans, such as personal loans and credit cards, typically have few or no collateral requirements. Others, such as mortgages, use the asset purchased using the loan (in the case of a mortgage, a residential or commercial property) as collateral.
Loans that involve collateral are referred to as secured loans. This is because the lender gains security through the collateral. If the borrower defaults on their loan payments, the lender can recover some or all of the amount owed by seizing and selling the collateral.
Advantages of Collateral
For borrowers, offering an asset as collateral has a range of benefits, from making a loan more affordable to providing an obvious, physical incentive to make repayments on time without any interruptions. The main advantages of offering collateral, as a borrower, include:
- Lower interest rates. Loans secured using collateral usually have lower interest rates than unsecured loans. By offering collateral, borrowers will often spend less on interest over the long term, making their loan significantly more affordable.
- Reduced risk for lenders. Loans are a two-way deal, meaning some things that help the lender can also help the borrower. By offering collateral, borrowers reduce risk for lenders and increase their chances of getting a favourable loan deal.
- Greater range of choices. By offering collateral, a borrower can usually choose from a wider range of loan options. Borrowers with assets to offer as collateral can also look at a range of lenders, then shop around to find the best deals.
- Longer payback periods. Paying back a loan over the long term can reduce strain on cash flow, making this an appealing option for small business borrowers. Many lenders are willing to offer longer payback periods for borrowers who offer assets as collateral.
For lenders, the primary benefit of collateral is that it reduces the risk of lending money. When a borrower has real estate, equipment or other assets to provide as collateral, lenders have some level of financial protection in the event that the borrower defaults.
Disadvantages of Collateral
There are also a few significant disadvantages of offering an asset as collateral, particularly for borrowers. These include:
- Need to own valuable assets. To provide an asset to offer as collateral, the borrower needs to own valuable assets in the first place. This makes it difficult for many younger borrowers to qualify for secured loans that require collateral.
As a result of this, many younger borrowers or borrowers with little credit history opt for unsecured credit, which typically has a significantly higher interest rate.
- Risk of losing the asset provided as collateral. If the borrower fails to repay the loan, they risk losing the asset provided as collateral. This can be a major problem if the asset used as collateral, such as a home, is essential for the borrower’s life and wellbeing.
For many businesses, being able to borrow money is essential. Offering an asset as collateral can make a borrower safer for banks and other lenders, increasing the level of access a small business owner has to a range of financing options.
Finally, collateral is important even outside of business. If you’re preparing to buy a house or any other valuable asset using borrowed money, it’s likely that the lender will require that the asset is used as collateral to secure the loan.