Something of value lent to act as a guarantee of performance.
What Is Collateral?
The term collateral refers to an asset that a lender accepts as security for a loan. Collateral may take the form of real estate or other kinds of investments, depending on the purpose of the loan. The collateral acts as a form of protection for the lender. That is, if the borrower defaults on their loan payments, the lender can seize the collateral and sell it to recoup some or all of its losses.
How Collateral Works
Before a lender issues you a loan, it wants to know that you can repay it. That's why many of them require some form of security. This security is called collateral which minimizes the risk for lenders. It helps to ensure that the borrower keeps up with their financial obligation. If the borrower does default, the lender can seize the collateral and sell it, applying the money it gets to the unpaid portion of the loan. The lender can choose to pursue legal action against the borrower to recoup any balance remaining.
As mentioned above, collateral can take many forms. It usually relates to the nature of the loan, so a mortgage is collateralized by the home, while the collateral for a car loan is the vehicle in question. Other assets can collateralize other nonspecific personal loans. For instance, a secured credit card may be blocked by a cash deposit for the same amount of the credit limit—$500 for a $500 credit limit.
Loans secured by collateral are typically available at substantially lower interest rates than unsecured loans. A lender's claim to a borrower's collateral is a lien—a legal right or claim against an asset to satisfy a debt. The borrower has a compelling reason to repay the loan on time because if they default, they stand to lose their home or other assets pledged as collateral.