What is Collateral?

Published by Thomas Herold in Banking, Economics, Investments, Real Estate

'Collateral' is explained in detail and with examples in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Collateral refers to an asset or piece of Real Estate which borrowers provide as security to lenders in exchange for a loan. This property actually secures the mortgage or other form of loan. In the event that the borrowers do not continue to make the agreed upon payments on the loan according to the laid out schedule, the financial institution has the right to seize this property in order to recover the principal losses.

Because such collateral provides at least nominal security to the lending institution in the scenarios where the borrower refuses to or is unable repay the loan, these forms of loans are commonly provided with lower interest rates as compared to those loans which are unsecured entirely. When such a lender has interest in the underlying property provided by the borrower then this is referred to as a lien.

In the end there are several arrangements with such collateral. The type of loan often determines which form will be required within the contract. With car loans or mortgages, the loans are secured by the property upon which the financial institution issues the loan. Other forms of loans have more flexible security, as with collateralized personal loans. In order for any loan to be called secured, the backing security has to be at least equal to or greater than the balance that remains on the loan in question.

Such secured loans entail far less risk for lenders because the underlying property serves as an incentive for the borrower to keep paying back the loan. Borrowers know all too well that if they do not complete the required payments then the financial institution which holds the loan may legally possess (or repossess) this collateral in order to recoup the money it is owed on the rest of the loan.

With mortgages, the collateral in question will always be the home that the borrower buys using the loan in the first place. If and when they fail to pay the debts, then the lender may seize possession of the property by utilizing a procedure called foreclosure. After the lender completes the necessary court process and has the property back in its possession, it is allowed to sell off the home to someone else. This will permit the bank to cover the principal which remains on the original loan along with their costs for the foreclosure.

Houses also can also be utilized for second mortgage collateral, or against HELOC’s (Home Equity Lines of Credit). In such scenarios, the credit delivered by the financial institution may not be greater than the equity which exists within the home itself. As a tangible example, a home could have a market value of $300,000. At the same time, it might be that $175,000 of the original mortgage balance remains to pay. This would mean that the majority of HELOC’s or even second mortgages would not exceed the available equity of $125,000.

Collateral is also utilized in margin accounts’ trading of stocks, commodities, and futures. In this case, it is the securities themselves that become the property which secures the brokerage loan. In the event that a margin call has to be issued and the account holder will not or can not pay it on demand, then the securities’ value ultimately makes certain that the brokerage will get back its loaned money.

Sometimes financial institutions will require additional collateral be put up for a given existing loan, if the contract allows such a scenario. This will reduce increasing risks for the lending institution. A creditor could give notice that without such additional security, they will be forced to raise the interest rate on the loan. Additionally accepted security could be certificates of deposit, cash, equipment, letters of credit, or even shares of stock.

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The term 'Collateral' is included in the Economics edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.