Collateral (finance)
Encyclopedia
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, any borrower failing to pay the principal and interest
under the terms of a loan obligation. If a borrower does default on a loan (due to insolvency
or other event), that borrower forfeits (gives up) the property pledged as collateral - and the lender then becomes the owner of the collateral. 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 a legal process
called foreclosure
to obtain real estate from a borrower who defaults on a mortgage loan obligation.
(also known as asset-based lending
). More recently, complex collateralisation arrangements are used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations, secured in the form of property
, surety
, guarantee or other as 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
. Another example might be to ask for collateral in exchange for holding something of value until it is returned. Some forms of lending are solely based on the strength of the collateral such as gold jewelry and property. Certain non-conservative lending practices such as lending against antique items or art works are also known to exist.
In many developing countries, the use of collateral is the main way to secure bank financing. The ease of acquiring a loan depends on the ability to use assets such as real estate as collateral.
Loan agreement
A loan agreement is a contract entered into between which regulates the terms of a loan. Loan agreements usually relate to loans of cash, but market specific contracts are also used to regulate securities lending....
, collateral is a borrower's pledge
Pledge (law)
A pledge is a bailment or deposit of personal property to a creditor to secure repayment for some debt or engagement, The term is also used to denote the property which constitutes the security....
of specific property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
to a lender, to secure
Secured loan
A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan...
repayment of a loan.
The collateral serves as protection for a lender against a borrower's default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
- that is, any borrower failing to pay the principal and interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
under the terms of a loan obligation. If a borrower does default on a loan (due to insolvency
Insolvency
Insolvency means the inability to pay one's debts as they fall due. Usually used to refer to a business, insolvency refers to the inability of a company to pay off its debts.Business insolvency is defined in two different ways:...
or other event), that borrower forfeits (gives up) the property pledged as collateral - and the lender then becomes the owner of the collateral. In a typical mortgage loan
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
transaction, for instance, the real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
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
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
. The bank uses a legal process
Legal process
Legal process , are the proceedings in any civil lawsuit or criminal prosecution and, particularly, describes the formal notice or writ used by a court to exercise jurisdiction over a person or property...
called foreclosure
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
to obtain real estate from a borrower who defaults on a mortgage loan obligation.
Concept of collateral
Collateral, especially within banking, may traditionally refer to secured lendingSecured loan
A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan...
(also known as asset-based lending
Asset-based lending
In the simplest meaning, asset-based lending is any kind of lending secured by an asset. This means, if the loan is not repaid, the asset is taken. In this sense, a mortgage is an example of an asset-backed loan. More commonly however, the phrase is used to describe lending to business and large...
). More recently, complex collateralisation arrangements are used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations, secured in the form of property
Property
Property is any physical or intangible entity that is owned by a person or jointly by a group of people or a legal entity like a corporation...
, surety
Surety
A surety or guarantee, in finance, is a promise by one party to assume responsibility for the debt obligation of a borrower if that borrower defaults...
, guarantee or other as collateral (originally denoted by the term security), whereas the latter often presents bilateral obligations secured by more liquid assets such as cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
or securities
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
, often known as margin
Margin (finance)
In finance, a margin is collateral that the holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterparty...
. Another example might be to ask for collateral in exchange for holding something of value until it is returned. Some forms of lending are solely based on the strength of the collateral such as gold jewelry and property. Certain non-conservative lending practices such as lending against antique items or art works are also known to exist.
In many developing countries, the use of collateral is the main way to secure bank financing. The ease of acquiring a loan depends on the ability to use assets such as real estate as collateral.
See also
- ConsignmentConsignmentConsignment the act of consigning, which is placing any material in the hand of another, but retaining ownership until the goods are sold or person is transferred. This may be done for shipping, transfer of prisoners, to auction, or for sale in a store Consignment the act of consigning, which is...
- Security interestSecurity interestA security interest is a property interest created by agreement or by operation of law over assets to secure the performance of an obligation, usually the payment of a debt. It gives the beneficiary of the security interest certain preferential rights in the disposition of secured assets...
- Credit riskCredit riskCredit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
- HypothecationHypothecationHypothecation is the practice where a borrower pledges collateral to secure a debt. The borrower retains ownership of the collateral, but it is "hypothetically" controlled by the creditor in that he has the right to seize possession if the borrower defaults...
- Cross-collateralizationCross-collateralizationCross-collateralization is a term used when the collateral for one loan is also used as collateral for another loan. If a person has borrowed from the same bank a home loan secured by the house, a car loan secured by the car, and so on, these assets can be used as cross-collaterals for all the loans...