All About Collateral


What is collateral?

When you apply for a secured loan from a lender, you’re required to pledge collateral as security. Collateral refers to a tangible or non-tangible asset of the borrower pledged as security for a loan. The loan amount that the lender may offer depends on the collateral offered by the borrower. Generally, the loan amount is equal to 80% of the collateral’s market value.

If a borrower defaults or is unable to repay his or her loan amount, the lender acquires the collateral submitted by him or her and uses it to recoup its losses. Collateral acts as a guarantee that the lender will get back the amount being lent to the borrower even if he or she is unable to repay the loan as agreed.

Getting a loan at an affordable interest rate is possible by pledging personal or professional assets as collateral. It can be your house, jewellery, car, fixed deposit, life insurance policy, bonds, unpaid invoices, etc.

KEY TAKEAWAYS

  • Collateral is essential to get a secured loan
  • Collateral is essential to get a secured loan
  • Lenders usually lend up to 80% of the collateral’s market value
  • Collateral reduces the risk of the lenders
  • The lender seizes collateral when a borrower defaults on a loan
  • Some examples of secured loans are Car Loans, Home Loans, and Loans Against Properties

What is the need for lenders for collateral?

Before approving your loan request, the lender will want to ensure that the loan amount can be paid back using the pledged collateral. The collateral serves as security for the lender and ensures that it will still receive its money even if the borrower is unable to repay the loan.

So, the need for collateral by the lenders can be justified for the following three reasons:

  • It is an asset owned by the borrower, who pledges it as a guarantee that he or she will repay the loan amount
  • Collateral remains in possession of the lender until the loan amount is completely repaid
  • By pledging the collateral, a borrower is bound to pay his or her loan EMIs or else he or she may lose his or her asset

Having collateral doesn’t fully mitigate the risk for a lender. It’s because collateral can lose its value over time, and acquiring the collateral in the case of loan default involves a lengthy process.

Points to remember before going for a collateralised loan

For lenders, collateral serves as a guarantee that the borrower will repay his or her loan amount. On the other hand, for borrowers, collateral helps in getting a loan at lower interest rates. But while opting for a collateralised loan, here are a few things borrowers should keep in their mind:

  • For a loan against collateral, the loan amount is calculated as per the market value of the collateral. Lenders offer up to 80% financing of collateral’s market value.
  • Make sure that your loan amount is in sync with the market value of your collateral. There’s no point in taking a lower amount loan by pledging a high-value asset.
  • The borrower remains the rightful owner of the asset even if it’s kept as collateral. The lender can acquire it only if he or she defaults on his or her loan.
  • The borrower may lose possession of his or her asset if he or she fails to repay the loan amount.
  • One should apply for a loan against collateral only if one is sure that he or she can clear the loan in time.

How does collateral work?

By availing of a loan against collateral, you can qualify for a higher loan amount and that too with lower interest rates. When you apply for a loan against collateral, the lender takes time to inspect your collateral and determine its market value. Then they decide the maximum loan amount that you can borrow based on the market value of the collateral.

For example, if you’re applying for a Loan Against Property, the lender will assign a surveyor to inspect your property. Based on the surveyor’s report, the lender will determine the current market value of your property. Then, it will offer you a loan amount of up to 70 to 80 per cent of your property’s market value.

If you agree, the lender will disburse the loan amount to your bank account and will keep the collateral as a mortgage. A loan-to-value ratio is a ratio between the loan amount and the collateral's value. Your asset would be kept as a mortgage with the lender until you repay your entire loan amount.

If you’re unable to repay your loan or a portion of your loan amount, the lender will acquire your asset and auction it. It will use the amount received from the auction to foreclose your loan account, and the remaining amount will be returned to you.

Which assets qualify as collateral?

Any tangible or intangible asset can qualify as collateral for availing of a loan. Some common examples of collateralised loans include Car Loans, Home Loans, gold loans, Loans Against Properties, loans against fixed deposits, etc.

Below are some examples of assets that can be used as collateral:

  • Real estate properties
  • A Loan Against Property or LAP is one of the most common types of collateralised loans. You can mortgage your residential or commercial property to avail of a loan against it. This is beneficial if you want to get a high-amount loan for a long tenure.

  • Inventory
  • You can mortgage your unpaid invoices to avail of a working capital loan for your business. If you’ve raised invoices but waiting to receive payments from your customers, you can use this facility.

  • Unpaid invoices
  • A Loan Against Property or LAP is one of the most common types of collateralised loans. You can mortgage your residential or commercial property to avail of a loan against it. This is beneficial if you want to get a high-amount loan for a long tenure.

  • Equipment
  • Your business equipment can also help you avail of financing at lower interest rates. Equipment financing is a strategy used by companies to obtain capital by pledging their existing equipment as collateral to buy new equipment through refinancing.

  • Gold
  • A loan against gold is another common collateralised loan that can help you meet your personal and professional financial requirements. You can pledge your jewellery or other forms of gold to obtain financing through this method.

  • Fixed deposits
  • You can also pledge your fixed deposits to avail of a loan against it. The loan amount is calculated based on the maturity value of the fixed deposit.

  • Crops
  • This is an exclusive financing method for farmers. They can pledge their crops as collateral to avail financing for their farming requirements.

  • Vehicles
  • Private or commercial vehicles can also be kept as collateral for availing of loans. In the case of Car Loans and Pre-Owned Car Loans, the vehicles are kept at mortgages with lenders.

  • Insurance policies
  • Life insurance policies with maturity values can help you avail of secured loans. You can keep your policy as collateral with the lender and avail of a loan against its maturity value.

Final words

Pledging their assets as collateral can help borrowers get high-value financing at competitive interest rates. It also assures the lender that it will get back its money. However, there are certain things that the borrower should keep in mind while applying for a loan against collateral. For instance, he or she should be wary of losing possession of his or her asset in the case of loan default.

Other Words

  • Credit Report
  • Credit Rating Agency
  • Capital Assets
  • Creditworthiness

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