What is a Collateral and How Does It Work?
Collateral is an asset that is used by a borrower as a security for a loan. The asset is pledged to a lender where the lender can sell the asset to recover the value of the loan in case the borrower defaults payment. These assets under collateral remain as properties of the borrower. A lien is placed on these assets which allows the lender to have control on the assets (and sell them) when borrower defaults payments as stipulated in the loan agreement. A way lender can recover the remaining loan amount.
A collateral offers a lender more security by allowing them to recoup any loss they may incur from payment default. Because of this, a loan that is supported by a collateral is offered with a much lower interest rate than an unsecured type of loan.
A collateral may be broken down into different types depending on the loan. It can be pre-determined by the lender based on the loan that is being secured such as real asset on a mortgage loan and the car being purchased on a car loan. There are instances where a collateral can be flexible especially when making a personal loan. A borrower must always note that for a loan to be secured by a collateral, the value of the collateral must be equal to or exceed the value of the loan. On the other hand, an asset that depreciates placed on collateral should have a year on year value of equivalent to or more than the loan value.
Another reason loans secured with a collateral creates less risk to a lender is that it pushes the borrower to pay the loan to avoid losing the asset. This is especially true with real assets that have been placed on collateral as most real assets appreciate rather than depreciate. The same motivations arise from an equipment as collateral as long as the value of the asset exceeds the value of the loan.
Lenders often prefer to grant a secured loan as these types of loan prove to be less risky for losses. If losses do arise, it is minimized by recouping through the collaterals that has been placed.