CollateralizationExplained & Defined
Collateralization refers to the word “collateral,” which is an asset offered as a form of security by a borrower in order to secure a loan.
In the event that the borrower was to default on the loan, the collateral would become the property of the lender, who could then sell the asset in order to compensate them for the loss of the unreturned funds.
Collateralization provides an important level of assurance for lenders to reduce the risk of borrowers defaulting on their loans.
It also allows borrowers to gain far lower interest rates due to the added assurance it offers lenders and allows individuals and businesses with poor credit histories to gain loans and interest rates that they may have otherwise been unable to obtain.
Generally, lenders are reluctant to issue loans without a guarantee that their money will be returned.
This is why banks and other lenders will look to credit scores.
However, even a high credit score is not a guarantee that a borrower will make their payments, and the cost and effort of taking a borrower to court may quickly exceed the value of the loan, even should they be successful in recovering the amount owed.
As a result, most businesses prefer to lend money to borrowers who can offer sufficient collateral to cover the risk of default.
With a collateralized loan, should the borrower fail to make payments on the loan, the lender has the right to seize any assets offered as collateral according to the terms of the loan agreement.
The collateral can then be sold in order to at least partially offset any losses resulting from the borrower’s failure to repay the outstanding balance of the loan.
This additional layer of security provides greater security for the lender, who can then, as a result, offer loans at lower interest rates relative to unsecured loans.
Collateral can take many forms, such as real estate, vehicles, works of art, financial instruments, machinery, securities, and even receivables.
The nature of collateral will generally depend primarily upon the type of borrower.
Collateralization is common for business loans used for expansion or to pursue business opportunities.
A company may choose to use equipment, equity, debt instruments, or other assets as collateral for the loan.
Generally, the amount of principal a bank will offer on a collateralized loan will depend primarily upon the value of the assets offered as collateral.
In most cases, lenders will offer a principal of approximately 70-90% of the estimated value of the collateral.
Collateralized loans are also common among loans for individuals as well as businesses.
Common examples of collateralized loans for individuals include mortgages, and car loans in which the property to be acquired serves as the collateral for the loan.
Types of Collateralized Loans
There are several types of loans for which lenders will often require collateral.
In some cases, a lender may issue these types of loans in the absence of collateral.
However, the borrower will generally incur higher interest rates.
- Mortgages: For home and real estate loans, the property being purchased is most commonly the collateral for the loan.
- Car Loans: Similarly to mortgages, the vehicle to be purchased is generally the collateral for the loan.
- Secured Personal Loans: Many lenders will require borrowers to designate a valuable piece of property to serve as collateral to secure a personal loan. This could be the borrower’s savings account, home, personal vehicle, jewelry, or a wide variety of other assets.
- Business Loans: In order to acquire business loans, borrowers may use a wide variety of assets as collateral. Common examples include real estate, inventory, receivables, financial instruments, and equipment.
- Secured Credit Cards: For secured credit cards, borrowers will generally provide a cash deposit to start the credit account as collateral. If the borrower fails to make payments, the lender can then keep the cash deposit.
Examples of Unsecured Loans
Not every loan requires the borrower to submit collateral.
In some cases, a potential borrower may not have property of sufficient value to offer as collateral.
However, these individuals still have options. Common examples of unsecured loans include:
- Credit Cards: Lines of credit exist for both businesses and individuals. These lines of credit generally do not offer the same level of capital as can be acquired with a collateralized loan, and interest rates may be several times higher.
- Unsecured Loans: As the name indicates, these loans are offered without any form of collateral and are available to individuals and businesses. However, borrowers may incur a far higher level of scrutiny and interest rate in order to acquire such a loan. They are generally only offered for smaller amounts than what can be acquired with a collateralized loan.
- Co-Signed Loan: A co-signed loan does not require the borrower to provide collateral. Instead, a second individual will co-sign the loan. This co-signer provides an additional level of security for the lender because, in the event that the borrower defaults on the loan, the co-signer is obligated to pay for the loan. This is a common practice for those without a credit history to acquire a loan.
- Payday Loans: Payday loans are another form of loan which does not require any form of collateral. However, in order to provide some degree of security, lenders providing these loans will often require permission to take money from a bank or credit card account or deposit a check when the payment becomes due. If the account lacks the fund or the check bounces, the lender may charge additional fees.
When a company issues secured bonds in order to raise capital, they are essentially creating a collateralized loan.
A secured bond means that the company issuing the bonds has attached an asset as collateral to the bonds so that if the company is incapable of repaying the holders of the bonds when they reach their maturity date, the collateral can be sold by the underwriters of the bond in order to at least partially repay the bondholders.
This greater level of security allows companies to offer bonds with lower interest rates which makes it easier to raise capital and pursue more investment opportunities.
This is particularly beneficial for companies without high credit ratings as a way to raise capital without exceptionally high-interest rates.
The use of collateral is a common practice in investing.
The practice of buying on margin allows investors to buy assets in part through the use of borrowed money.
This money is borrowed from banks or brokers by offering other securities in the borrower’s investment account as collateral.
Assuming that an investor possesses a suitable amount of assets in their account, brokerage firms will allow the investor to borrow money to purchase additional securities using their existing assets as collateral.
If the new investments are successful, the funds loaned will be repaid using the profits.
However, if the investments lose money, then the investor will be required to repay either through making a new deposit or through the sale of the assets within their account.
Brokers will require that investors maintain a certain value of investments in their accounts in order to provide sufficient collateral.
If the investor’s account drops below this value, most commonly due to some of their investments dropping in value, it will trigger a margin call.
This means that the investor must make an additional deposit of funds, or the broker may force the investor to liquidate assets in the account in order to meet the margin call.
In order to better understand collateralization here are a few examples.
For an example of collateralization, consider an investor who decided to purchase a plot of land for $2,000,000.
In order to purchase this property, the investor decides to apply for a loan with Bank X and offer the property to be purchased as collateral for the loan.
In order to judge whether or not to make the loan, Bank X looks to the value of the property, which it estimates to be $1,600,000.
Because the bank has a policy of offering loans if the collateral exceeds 75% of the loan amount and the property is worth more than this amount, Bank X chooses to issue the loan.
For another example of collateralization, let us consider how it is used in investing.
In margin buying, investors use borrowed money to buy new investments while offering their existing securities as collateral.
Generally, brokers or banks will require a certain percentage of the amount loaned to be maintained in the investor’s account as collateral for the loan.
Assume that an investor chooses to borrow $7,000 in order to buy on margin and that the brokerage requires 50% of the value to be backed as collateral.
This means that the investor will need to maintain $3,500 in their account in order to serve as collateral for the loaned amount.
- Collateralization is a mechanism of offering assets as a way to secure a loan against the possibility that a borrower will default on payments.
- Because a lender’s risk will be substantially lowered when a loan is collateralized, they will generally charge far lower interest rates.
- In the event that a borrower was to default on a collateralized loan, the lender can seize the asset that was offered as collateral and sell it in order to offset their loss in making the loan.
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Williams "Debt Collateralization, Capital Structure, and Maximal Leverage" White paper. May 2, 2022