When offering you a loan, lenders want to limit their risk as much as possible and ensure they get their money back. That’s where collateral comes in.
Collateral is something — some sort of property or asset — that you may need to provide to a lender to get a loan. In many cases, collateral is required for certain types of loans, like mortgages and auto loans.
Let’s assume you would like to borrow $100,000 to start a business. Even if you have an excellent credit rating a bank may be reluctant to lend you the money because it may be left with nothing if you default on the loan.
Thus, the bank may require $100,000 of collateral in order to lend you the money. This collateral might consist of financial instruments, houses, cash, or even objects such as art, jewelry, or other items. You might also pledge your business receivables as well.
On a mortgage, for instance, the collateral is the home the mortgage was used to buy; on an auto loan, the collateral is the car the buyer drives home from the dealership. Essentially, the collateral serves as a security measure for the lender.
If you fail to make payments, your lender typically can take possession of the collateral as payment for the loan. It can be a win-win for lenders and borrowers. It gives lenders more confidence, and it may score borrowers a lower interest rate.
Why Does Collateral carry importance?
Collateral is security, which is why collateralized loans often receive better interest rates than unsecured loans since the lender bears less risk.
A secured loan is a loan given out by a financial institution where an asset is used as collateral or security for the loan. For example, you can use your house, gold, etc., to avail of a loan amount that corresponds to the asset’s value. The risk is if you can’t repay a secured loan, the lender can sell your collateral to pay off the loan. Examples of secured loans
● Loan against property
● Car loan
Unsecured loans, like the name suggests, is a loan that is not secured by collateral such as land, gold, etc. These loans are comparatively riskier to a lender and therefore associated with a high-interest rate. When a lender releases an unsecured loan, he does so after evaluating your financial status and assessing whether or not you are capable of repaying your loan.
“19.1 million consumers currently have an unsecured personal loan, compared to the 176 million Americans with credit cards”
– Chamber of Commerce
Examples of unsecured loans
● Credit cards
● Student loans
“As of March 2018, outstanding unsecured loans stood at around Rs 5 trillion, accounting for 26 percent of retail lending, compared to 21% three years ago”
-The Economic Times
There are five main types of collateral: consumer goods, equipment, farm products, inventory, and property on paper
Consumer goods are products purchased by the mainstream consumer, such as an automobile.
Equipment includes items predominantly used in business or government operations.
Farm products include livestock and crops.
Inventory consists of raw materials or work-in-progress.
Property on paper includes stocks, bonds, and even funds held in a savings or checking account.
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