Introduction
Collateral is the asset offered to the lender by a borrower as a loan; the decrease in risk to the lender, given that the lender will recover his or her loan if the borrower defaults, ensures that better terms are awarded to a borrower who pledges collateral. A borrower pledging collateral often obtains better terms on which the loan is advanced by the lender.
Loans can be secured by collateral in various forms , ranging from real estate, machinery, stocks, or even gold . The advantages depend on the choice made based on the borrower ‘s assets and the lender ‘s needs . To handle risk and opportunity, it is therefore important that a borrower understands how to operate with collateral, which is also relevant to lenders.
Collateral
Collateral is any immovable or movable property that you can offer to the lender in lieu of a loan. In the case of default , the lender can take over the collateral and recover the loan amount. Collateral serves as security to the lender.
Loans taken against collateral are known as secured loans. Loans that do not involve collateral are called unsecured loans. The lender desires to minimize risk as much as possible when granting any loan.
How Collateral Work
Loan Agreement: The loan contract deals with an agreement between the borrower and lender wherein security for the loan shall be provided by the borrower to the lender.
Collateral Valuation: Collateral valuation is the term used to refer to how the lender establishes whether or not there is enough collateral that can support the loan amount.
Loan Approval: In loan approval, a lender approves the loan based on the qualification of the offered collateral at an interest rate much better than what one would get on an unsecured loan.
Repayment: Repayment the loan is repaid as agreed upon by the borrower and the lender.
Collateral Recovery: In case the borrower fails to repay the loan, the lender will seize the collateral and offer it for sale to recover the unpaid loan balance.
Types of Collateral Loan
Loan against Securities: Here, banks and other financial institutions offer loans against securities, which can be shares, mutual fund units, or bonds. The LTV is relatively lower compared to loans against other asset classes since the assets are riskier and involve volatility.
Loan against property: Here, the real estate property can be used as collateral security by a borrower and avail of a loan from the financier. This is one of the most common types of collateral finance availed of by the borrowers mainly because of the interest rates that it attracts are lower, and enormous borrowing is possible as property can be given as collateral security. Property is less volatile in nature and serves as a safe asset for the lender. This option of loan against property can be availed for both residential and commercial properties.
Loan against gold: This is another form of loan against collateral availed to the applicant where they can submit gold and receive the loan from the lender. The gold also serves as an outstanding asset, thus qualifies to be financed.
Loan against FD: FDs can be offered as collateral to raise loans from banks and other monetary organizations. Since the Bank issues the FD, it carries a lock-in period. There can be penal charges towards premature withdrawal of FDs or even a loss of interest to the depositors. Hence a good way out is to get the loan raised against the FD given as collateral security. In addition, many institutions allow the interest from the FD to be set off against the loan, which reduces the net rate on the loan.
Machinery loan: Bank and financial institutions offer credit facilities by taking machinery on collateral security. This, in essence, is a sort of relief for entrepreneurs seeking finance but who do not wish to expose personal assets to pledge as collateral.
Conclusion
A high level of importance is attached to lending because, through collateral, it allows borrowers to have security in addition to lenders. Collateral loans help mitigate lender risk because, through the offer of real estate or securities, among other fixed deposits, borrowers can obtain a loan with a more favorable set of terms. There are various types of collateralized loans , each with specific benefits and suited for particular financial purposes. Financial accessibility and security are facilitated through collateralized loans, making them integral to the lending and borrowing process.