In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan. The collateral serves as protection for a lender against a borrower's default—that is, it can be used to offset the loan to any borrower failing to pay the principal and interest under the terms of a loan obligation. The protection to a lender that collateral provides allows lenders to offer a lower interest rate on loans that have collateral compared to those that don't because the risk of loss to the lender is lower. The reduction in interest rate is up to several percentage points depending on the type and value of the collateral. If a borrower does default on a loan (due to insolvency or other event), that borrower forfeits (gives up) the property pledged as collateral, with the lender then becoming the owner of the property. In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. Should the buyer fail to pay the loan under the mortgage loan agreement, the ownership of the real estate is transferred to the bank. The bank uses the legal process of foreclosure to obtain real estate from a borrower who defaults on a mortgage loan obligation. A pawnbroker is an easy and common example of a business that may accept a wide range of items as collateral rather than accepting only cash.
Concept of collateral
Collateral, especially within banking, traditionally refers to secured lending (also known as asset-based lending). More complex collateralization arrangements may be used to secure trade transactions (also known as capital market collateralization). The item that is used as collateral provides security to the lender, to help ensure that they will get their money back even if the borrower is not able to satisfactorily repay the loan in full. The former often presents unilateral obligations secured in the form of property, surety, guarantee or other collateral (originally denoted by the term security), whereas the latter often presents bilateral obligations secured by more liquid assets such as cash or securities, often known as margin.
Marketable collateral is the exchange of financial assets, such as stocks and bonds, for a loan between a financial institution and borrower. To be deemed marketable collateral, assets must be capable of being sold under normal market conditions with reasonable promptness at current fair market value. Conditions are based upon transactions in an auction or similarly available bid, or ask price market. For national banks to accept a borrower’s loan proposal, collateral must be equal or greater than 100% of the loan or credit extension amount. The bank’s total outstanding loans and credit extensions to one borrower may not exceed 15 percent of the bank’s capital and surplus, plus an additional 10 percent of the bank’s capital and surplus.[where?]
Reduction of collateral value is the primary risk when securing loans with marketable collateral. Financial institutions closely monitor the market value of any financial asset held as collateral and take appropriate action if the value subsequently declines below the predetermined maximum loan-to-value ratio. The permitted actions are generally specified in a loan agreement or margin agreement.
- Security deposit
- Security interest
- Credit risk