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, with the lender then becoming 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 the legal process of foreclosure to obtain real estate from a borrower who defaults on a mortgage loan obligation. A pawnbroker is an easy and common example of a business that may accept a wide range of items rather than just dealing with cash.
Concept of collateral
Collateral, especially within banking, traditionally refers to secured lending (also known as asset-based lending). More recently, complex collateralization arrangements are used to secure trade transactions (also known as capital market collateralization). The item that is used as collateral provides security to the lender, letting them know that they'll get their money back whether or not you're able to satisfactorily repay the loan. 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 for margin.
Marketable collateral is the exchange of financial assets, such as stocks and bonds, for a loan between a financial institution and borrower. To be deemed marketable collateral, assets must be capable of being sold under normal market conditions with reasonable promptness at a fair market value. Conditions are based upon actual transactions on an auction or similarly available daily bid, or ask price market. For national banks to accept a borrower’s loan proposal, collateral must be equal or greater than 100% of the loan or credit extension amount. The bank’s total outstanding loans and credit extensions to one borrower may not exceed 15 percent of the bank’s capital and surplus, plus an additional 10 percent of the bank’s capital and surplus.
Declination of collateral value is the primary risk of securing loans with marketable collateral. Financial institutions closely monitor the market value of any financial asset held as collateral and take appropriate action if the value subsequently declines below the predetermined maximum loan-to-value ration.
- Security deposit
- Security interest
- Credit risk