What is Collateralization？
Collateralization is the process of securing a loan with a valuable asset, which is referred to as collateral. The borrower provides an asset to secure the loan and in the event of default, the lender can take possession of the asset to cover the debt. Collateral-backed loans offer lenders protection against default risk. As a result, collateralized loans typically bear substantially lower interest rates than unsecured loans, and offer a solution to borrowers with less than perfect credit.
As collateral, lenders generally prefer assets that are easy to value and liquidate. Real estate, securities, and cars, as well as jewelry, art, or other valuables, can all serve as collateral. In addition, companies sometimes pledge equity capital or receivables as collateral for commercial loans.
The type and amount of collateral required for a loan is often a matter of negotiation between the borrower and lender. For instance, a lender may require a borrower to collateralize any assets purchased during the loan period. In some cases, collateral for one obligation can also be used as collateral for other obligations in what is called cross-collateralization. This often occurs in real estate transactions, where a property is pledged as collateral for more than one mortgage.
Key Learning Points
- Collateralization is the process of securing a loan with valuable assets, which protects lenders from the risk of default.
- If the borrower defaults on a collateralized loan, the lender can seize the collateral and sell it to recover the outstanding balance of the loan.
- Banks charge significantly lower interest rates for collateralized loans than for unsecured loans because the risk to the lender is reduced.
How Does Collateralization Work?
In many cases, banks are reluctant to offer unsecured loans even to borrowers with excellent credit ratings as they fear the loss of default. While banks have the option of suing borrowers, litigation is expensive and time-consuming. Banks are more willing to lend to borrowers who provide collateral since their risk is substantially reduced.
Since collateralization mitigates risk, lenders are generally willing to lend more money at lower rates, which reduces financing costs for the borrower. The principal amount of a collateralized loan is usually based on the collateral’s appraised value. Most lenders will loan between 70% and 90% of the collateral value.
Common Types of Collateralized Loans
Collateral can secure business or personal loans. The two most common types of collateralized loans are home mortgages and car loans. In both cases, the lender can repossess the home or car if the borrower defaults on the loan.
Collateralized borrowing is also common in the commercial sector, where business owners use property, stocks, or bonds as collateral for loans. In the event that the business defaults, the underwriters can seize the collateral assets, sell them, and repay investors.
Securities are often used as collateral in investing. Buying on margin involves purchasing securities with borrowed money while using other securities in the borrower’s account as collateral. The collateral provided for a margin loan is called the margin and is a percentage of the total amount borrowed. Suppose a client borrows $8,000 for margin trading, and the brokerage takes 30% of the loan as collateral. The borrower must post $2,400 worth of securities as collateral for the loan. If the collateral value declines below $2400, the broker will issue a margin call and the borrower will need to provide additional cash or securities to return the collateral value to the 30% threshold.
- Collateralization is the process of securing a loan by offering assets to the borrower as
- Collateral reduces risk to the lender while lowering financing costs for the borrower.
- Banks and financial institutions consider a maximum loan-to-value ratio, typically between 70 and 90 percent, before releasing loans to individuals or businesses.
- Collateralization helps borrowers with lower-than-average credit to obtain financing and build credit, but the borrower risks losing the collateral if they default.
Test Your Knowledge – Collateralization MCQ
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