Collateral is something that helps secure a loan. When you borrow money, you agree (somewhere in the fine print) that your lender can take something and sell it to get their money back if you fail to repay the loan. Collateral makes it possible to get large loans, and it improves your chances of getting approved if you’re having a hard time getting a loan.
When you pledge collateral, the lender takes less risk, which means you're more likely to get a good rate.
What Is Collateral?
Collateral is an asset that a lender accepts as security for a loan. If the borrower defaults on the loan payments, the lender can seize the collateral and resell it to recoup the losses.
How Collateral Works
Loans that are secured by collateral are typically available at substantially lower interest rates than unsecured loans. The borrower has a compelling reason to repay the loan on time. If the borrower defaults, the lender can seize the property and sell it to recoup some or all of the losses.
A lender's claim to a borrower's collateral is called a lien.
Types of Collateral
In order to be able to take out a loan successfully, every business owner or individual should know the different types of collateral that can be used when borrowing.
1. Real estate
The most common type of collateral used by most borrowers is real estate, such as one’s home or lot parcel. Aside from being easily available, such properties come with a high value and low depreciation. However, it can also be risky because if the property is sequestered due to a default, it cannot any longer be taken back.
2. Cash secured loan
Cash is another common type of collateral because it works very simply. An individual can take a loan from the bank where he maintains active accounts, and in the event of a default, the bank can liquidate his accounts in order to recoup the borrowed money.
3. Inventory financing
This involves an inventory that serves as the basis for the release of a loan. Should a default happen, the things listed in the inventory will be sold.
4. Invoice collateral
Invoices are one of the types of collateral used by small businesses, wherein invoices that are still unpaid are used as collateral.
5. Blanket liens
This involves the use of a lien, which is a legal claim allowing a lender to dispose of the assets of a business that is in default of its loan.