Collateral refers to the assets pledged by a borrower in a secured loan.
Collateral can sometimes be voluntarily offered by a borrower, specifically requested by a lender, or a default requirement due to the nature of the loan facility.
For example, the default collateral for a home loan is the property in question. And the default collateral for an auto loan is the vehicle in question.
Common collateral include:
- Real estate
- Personal property
- Treasury bonds
- Collectible cars
- Items of value
The main purpose of collateral is to serve as a backup plan to protect a lender should the borrower be unable to meet his debt obligation and repay the loan in future.
In the event of defaults and delinquency, a lender will have the legal right to take possession of the assets and personal property used as collateral.
After which, liquidate them to pay for the outstanding balance owed.
Excess sales proceeds from the sale (overage) will be returned to the borrower.
However, if the bank manages to acquire the house for the amount owing via their opening bid at auction, there will be no leftover for the borrower.
Collateralized debt generally come with lower interest rates and better terms than unsecured debt.
This is because they are of lesser risks to lenders. And lower risks means lower returns. Resulting in lower interest rates.