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Concept
Collateral (finance)
Summary
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 and so 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. The reduction in interest rate can be up to several percentage points, depending on the type and value of the collateral. For example, the Annual Percentage Rate (APR) on an unsecured loan is often much higher than on a secured loan or logbook loan.
If a borrower defaults on a loan (due to insolvency or another event), that borrower loses 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. If the buyer fails 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. If a second mortgage is involved the primary mortgage loan is repaid first with the remaining funds used to satisfy the second mortgage. A pawnbroker is a common example of a business that may accept a wide range of items as collateral.
The type of the collateral may be restricted based on the type of the loan (as is the case with auto loans and mortgages); it also can be flexible, such as in the case of collateral-based personal loans.
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).
Official source
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