Collateral

Definition

Collateral refers to assets or property that a borrower pledges to a lender as a security for a loan.

What is collateral?

This serves as a guarantee for the lender that if the borrower is unable to repay the loan, the lender can seise and sell the collateral to recover the borrowed amount.

Collateral can take various forms, such as real estate, vehicles, equipment, inventory, or even financial assets like stocks or bonds. It provides a level of assurance for lenders and allows borrowers to access loans they might not otherwise qualify for.

Types of collateral

The type of collateral is typically determined by the type of loan. For instance, when you get a mortgage, your home serves as the collateral. Similarly, if you take out a car loan, the car itself is the collateral. Lenders commonly accept various forms of collateral, such as fully paid-off cars, bank savings deposits, and investment accounts. However, retirement accounts are generally not accepted as collateral.

Which loans do not require collateral?

Loans that do not require collateral are typically known as unsecured loans. These include personal loans, student loans, and most types of credit cards.

With unsecured loans, lenders rely on the your creditworthiness and financial history rather than any physical asset to secure the loan. Interest rates for these loans tend to be higher compared to secured loans, as they pose a greater risk to the lender.

Example of using collateral

Sarah wants to purchase a car and decides to finance the purchase through a bank loan. ABC Bank agrees to provide Sarah with a secured car loan.

1. Loan amount:
   • Sarah needs £20,000 to buy the car. ABC Bank approves the loan and provides her with the funds.
2. Collateral:
   • To secure the loan, Sarah pledges the car she intends to purchase as collateral. The car’s value is estimated at £25,000.
3. Use of funds:
   • Sarah uses the £20,000 loan from ABC Bank to purchase the car.
4. Ownership and collateral agreement:
   • As part of the loan agreement, ABC Bank places a lien on the car, meaning that until Sarah repays the loan, the bank has a legal claim to the car.
5. Repayment:
   • Over the loan term, Sarah makes monthly payments to ABC Bank, covering both the principal amount borrowed and the accrued interest.

If Sarah fails to make the agreed-upon payments and defaults on the loan, ABC Bank has the right to take possession of the car, sell it, and use the proceeds to recover the outstanding loan balance.