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 a lender's protection against a borrower's default—that is, it can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.
The protection that collateral provides generally allows lenders to offer a lower interest rate on loans that have collateral compared to those that do not, because the risk of loss to the lender is lower. The reduction in interest rate can be up to several percentage points, depending on the type and value of the collateral.
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 property. 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 repay the loan according to the mortgage agreement, the lender can use the legal process of foreclosure to obtain ownership of the real estate. A pawnbroker is a common example of a business that may accept a wide range of items as collateral.
Concept of collateral
Collateral, especially within banking, traditionally refers to secured lending (also known as asset-based lending). More-complex collateralization arrangements may be used to secure trade transactions (also known as capital market collateralization). The former often presents unilateral obligations secured in the form of property, surety, guarantee or other 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 as 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, assets must be capable of being sold under normal market conditions with reasonable promptness at current fair market value. For national banks to accept a borrower's loan proposal, collateral must be equal to 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.
Reduction of collateral value is the primary risk when securing loans with marketable collateral. Financial institutions closely monitor the market value of any financial assets held as collateral and take appropriate action if the value subsequently declines below the predetermined maximum loan-to-value ratio. The permitted actions are generally specified in a loan agreement or margin agreement.