What is collateral?
- “Collateral” is an asset left to a lender so that a borrower will be motivated to pay the debt. It assures the lender that the money credited will be spent in due time.
- If the borrower fails to pay the loan, the lender has the right to seize the property. While the collateral is in the lender’s possession, the lender may profit by selling the collateral or earning from the asset. This claim is called a “lien.”
- Since collateral offers some security to the lender, the borrower may ask for lower interest rates for the money borrowed.
The purpose of collateral
Imagine a farmer who just reaped a fruitful harvest, giving this lucky farmer a bounty of cash. One day a friend approaches the farmer and asks to borrow some money. The kind-hearted man agrees to lend his friend the money but begs to be paid back in a month. After a month, his friend refuses to pay him. It is almost planting season, and he needs the money he lent to buy seeds and fertilizer. Now that the friend is nowhere to be found, the farmer is at a loss on how to finance his business. This scenario could have been avoided if the collateral was part of the agreement.
The same thing also happens in more significant transactions. In modern society, banks and funding agencies ask for collateral before they issue loans. Banks need some assurance that they will get the loan back. After all, cash is the lifeblood that keeps the banking industry alive. They have to be sure that the money they use for their clients’ credit will not affect their other services and operations. Otherwise, they will go bankrupt.
What can be considered collateral?
Not every item on your asset list can be considered collateral. It should be commensurate with the amount of loan you require. Notable examples of collateral are luxurious chattels like cars and jewelry. For more notable transactions, properties like land and housing units are often presented as collateral.
If collateral is often associated with monetary debt, where do credit cards fit in? Credit cards allow the purchaser to acquire an item without using the cash available on hand. How much the purchaser owes the bank will be paid at a later date, depending on the agreement. Whenever a credit card user cannot settle a debt, the bank may impose high-interest rates until the loan is paid. It this case, the fear of paying high-interest rates becomes some sort of collateral.
What if the collateral is damaged upon return?
Part of the agreement between the lender and the borrower stipulates the return of the collateral in excellent condition. In case of any damages to the collateral that decreases its utility or value, the burdened party may file a lawsuit to charge for the costs. The obligation may fall to the party or both parties depending on the situation.
For example, imagine the collateral is a car and is currently under the control of the lender, which in this case is a bank. Then, some bank employee drove the vehicle, crashed and damaged the car. The responsibility of not only repair but also other costs goes to the lender.
In another case, let’s say that the collateral is a house and was damaged by a disaster. The lender may raise interest rates if the debt is not yet settled if the loan agreement allows it. Whenever real property is under any insurance and damage has been inflicted before the loan is resolved, the insurance money will automatically go to repaying the loan.
There are many forms of collateral, and the arrangement varies according to local laws and the contract between the lender and borrower. Knowing how collateral works can help you formulate a sound investment and personal finance plan.