What is Collateral Loan - How Does It Work and Pros & Cons Of Collateral Loan
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Have you heard of the term "Collateral"? Want to know more about Collateral? You've found the proper blog if the answer is yes. Have you ever taken a loan from the bank? If you have taken it, you must know that the bank pledges your assets for giving the loan. Those who belong to the corporate world must know that pledging Collateral helps borrowers pay debts at better rates. Today in this blog, we will have an in-depth discussion about Collateral – what is Collateral and how it plays a role in getting a loan, as well as how Collateral works.
It is an ancient practice to convince the lender to offer something of value to get the money loaned. Its parts are seen in India and ancient civilizations like Greece and Rome, a fundamental finance concept. However, some changes in its concept made it asset-backed and are now known as Collateral. So without delay, let's jump into it.
What Is Collateral?
Let's talk about the simple definition of Collateral. The collateral value is something that a borrower can pledge to obtain a loan or line of credit from the lender. To secure the loan, the borrower must pledge both tangible and intangible assets to the lender. Common examples of Collateral include vehicles, investments, cash, and real estate. Collateral reduces the risk of the lenders and secures the financing. In addition, Collateral helps borrowers access higher debt amounts at lower interest rates.
If you want a loan to finance your business, the first thing to consider is what to pledge as Collateral. Then, we will tell you further how Collateral works.
How Does Collateral Work?
When you apply for a loan in any financial institution, that institution evaluates your repayment capabilities before approving the loan application. There is no doubt the reason behind it - they want security on their debts to cover the risk.
If viewed from another perspective, the Collateral serves as a piece of evidence. It also guarantees the lender that the borrower intends to repay his loan. However, not all loans necessarily require Collateral. Instead, the Collateral acts as a guarantee for the lender, i.e., if the borrower cannot repay the loan, the lender can reduce his risk by using that Collateral to recover the outstanding loan. Collateralized loans are also commonly known as secured loans.
For your information, the nature of the loan decides what your Collateral will be. Let us understand this with an example – If you apply for a home loan, its Collateral will be the asset. But on the other hand, if you borrow money to buy a car, the Collateral is the car itself.
The lender also does not face any problem granting the loan when the Collateral is there, as the lender has a claim for the Collateral in case the loan is not repaid. This process is known as a lien. If the debt is not paid back, the lender may sell the Collateral to recoup the unpaid amount. Therefore, before granting a loan, the lender assesses the value of the Collateral to see if its value is the same as that of the loan. There are also instances where the lender does not shy away from taking legal action to recover its dues when the value of the Collateral is insufficient.
What Are The Types Of Collateral?
As we told you above, the type of Collateral can depend on the nature of the loan. Primarily it includes assets such as inventory, property, and equipment. Alternative assets are also included in the Collateral. Below are some of the common asset classes that are used as Collateral –
Real Estate: Home Equity Lines of Credit (HELOCs), LAPs, Home Equity Loans, and Home Loans secured against real estate. Such Collateral can also be used for personal finance or business loans. Borrowers with such assets can use this asset to secure business and personal loans.
Savings Account: Borrowers with no collateral assets are ready to pledge their savings account in lieu of a loan. Provided the loan has sufficient funds in the savings account. Often this form of Collateral is used when taking out a personal loan.
Car or other vehicles: As a borrower, you can mortgage your car or other vehicles. If you want to take a vehicle loan, you can pledge your car or other vehicles as Collateral. Until the loan is repaid, the lender is the car's legal owner.
Inventory: Inventory is used as Collateral when a debt is taken for the short term.
Cash: You might be surprised to know that, but it is true. Often the borrowers pledge cash to secure the loan. One way is in the form of a down payment. The cash is forfeited in case the borrower makes any default in repayment of the loan.
Investment: In some cases, it has also been observed that the borrower may offer his investment accounts as Collateral to the lender in lieu of the loan. This lending is known as stock-based or securities-based lending. However, if you do, remember that it may affect your investment account. If the value of your investment falls below the outstanding loan amount, the lender may ask you for additional Collateral.
Equipment: Companies often use this strategy. Companies use equipment as Collateral when they take out loans to raise funds.
What Type Of Loans Require Collateral
Let us inform you that one of the most well-known secured loans is the mortgage. When the borrower seeks financing for a real estate property or home, they can pledge the property as Collateral so that the bank's risk is limited in case of foreclosure or default. When the borrower fails to make payments to the lender, the bank has the right to confiscate the property.
The second most popular collateralized loan with a mortgage is the auto loan. For auto loans, any other vehicle is pledged as Collateral. For example, suppose you put the car as Collateral for an auto loan. In this case, the lender keeps the car's ownership until the loan is paid, and if you fail to repay the loan, the financial institution can confiscate your car.
Secured Personal Loan
We want to clarify that not all secured personal loans require Collateral. But secured personal loans require the borrower to pledge Collateral to reduce the lender's risk. In addition, secured personal loans make it easy for applicants with low credit scores to approve loan applications. Also, borrowers get loans at low-interest rates.
Secured Credit Card
Undoubtedly, getting a credit card can be difficult if you do not have a developed credit history or have a very low credit score. Building a credit history becomes even more difficult when the credit score is low. But some banks and financial institutions offer secured credit cards. In exchange for this type of secured credit card, the bank gives you credit equivalent to the cash held in the in-house account and pledges it as Collateral.
Pros Of Collateral Loan
The biggest plus point of collateralized loans is that it allows borrowers to make timely payments.
When borrowers make timely repayment of loans, it helps them to improve their credit scores, and new borrowers can develop their credit history.
Collateralized loans also have the unique advantage of making loans to those with bad credit or little credit history much easier.
Borrowers who provide Collateral can also access larger loan amounts than unsecured financing.
In addition, secured loans and credit cards have lower interest rates than unsecured loans.
Cons Of Collateral Loans
A collateralized loan has advantages as well as certain limitations. Or rather, it has some negative aspects as well. Let's see:-
The biggest downside of a collateralized loan is that if the borrower defaults on the loan's repayment, the borrower may risk their assets pledged as Collateral for the loan.
Another downside is that the application process for secured loans can be lengthy, as the appraisal takes time.
The borrower can use the loan only to fulfill the loan objectives. For example, if you have taken a home loan, that loan can be used only for buying property.
Lastly, Collateral can also be used by small businesses. They can give their business assets as security to the lender instead of getting a loan for their business. The use of collateral loans benefits both the borrower and the lender. While on the one hand, the borrower gets the loan despite having a bad cibil score; on the other hand, the assets available with the lender as Collateral reduce their risk. But that does not mean that you should not keep its negative side in mind. A decision should be reached keeping in mind the negative aspects of collateral loans. There are many other ways to get a loan; you can consider them all.
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Frequently Asked Questions
Simple definition of collateral is something that a borrower can pledge to obtain a loan or line of credit from the lender. To secure the loan, the borrower must pledge both tangible and intangible assets to the lender
The major advantage of collateralized loans is that it makes loans to those with bad credit or little credit history much easier.
Yes, you can avail collateral loans much faster than other types of loans.