Collateral is property or other asset(s) that a borrower offers as a way for a lender to secure a loan.
Assets which do not yet exist or belong to someone else are not considered collateral – for example – future earnings, and / or property you intend to purchase.
For a mortgage, the collateral is the house purchased with the funds from the mortgage. If payments on the debt cease, the lender can take possession of the house through a process called foreclosure. Once the property is in the lender’s possession, the lender can sell the property to recover the remaining principal on the prior loan.
A home may also function as an asset on a second mortgage or a home equity line of credit (HELOC). In these instances, the amount provided as credit does not exceed the available equity in the home. For example, if a home is valued at $200,000, and $125,000 remains on the primary mortgage, most second mortgages or HELOCs are not available in amounts above the remaining equity of $75,000.
The type of collateral for a loan may be predetermined based on the loan type, such as with a mortgage or an auto loan, or may be flexible, such as a collateralized personal loan. For a loan to be considered secure, the value of the collateral must meet or exceed the amount remaining on loan.
When securing a loan, issuers use collateral to increase the likelihood of repayment. Additional collateral can include cash, certificates of deposit, equipment, stock or letters of credit.
Since collateral offers some security to the lender should the borrower fail to pay back the loan, loans that are so secured have lower interest rates than unsecured loans. For a loan to be considered secure, the value of the assets must meet or exceed the amount remaining on loan. Offering additional collateral can help a borrower qualify for more favorable interest rates.
Sometimes a lending institution requires more collateral than the borrower can put up to have more security for the loan. When a borrower will be acquiring additional assets such as property in the near term, a lender may choose to issue the loan anyway. Then when the borrower receives those assets, they would be automatically collateralized.
Business Loans / Corporate Finance
Businesses often structure the use of assets in their request to acquire corporate finance. Using securities is also common in investing. Securities use is regulated by government legislations and primarily overseen by the Federal Reserve. Many brokerage firms offer margin borrowing which allows an investor to obtain a loan with securities in their account. Often brokerages will not allow margin borrowing until an account reaches a certain limit.
A margin loan may be an alternative approach to help meet short-term financial needs that are not related to trading. In fact, using this type of loan rather than selling existing securities or using cash on hand can help to avoid disruption to your long-term investing goals and could help you avoid potential tax consequences of selling securities.
Collateral in Margin Trading
In margin trading, the securities in your brokerage account act as collateral in case of a margin call. Similar to the security offered by loan collateral in the event a borrower becomes unable to make payments, the value of the securities functions as assurance that the institution can recover funds.
When you borrow money with a credit card, there is no collateral. To compensate for the additional risk associated with default, credit card debt often carries a significantly higher interest rate than mortgage or auto loan debt.
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