In business, the term collateral usually refers to assets or other property pledged by a borrower to secure repayment of a loan. The concept is defined here in the context of related terms, including surety, asset-based lending, and secured lending.
Collateral is the lender's protection in case the borrower defaults, that is, fails to pay principal or interest, as agreed in the loan contract. In case of default, the lender takes ownership of the collateral.
Explaining Collateral in Context
Sections below further describes collateral in context with lending-related terms including:
- What is "collateral?"
- What is the role of collateral in secured lending (asset-based lending)?
- What happens when the borrower defaults on an unsecured loan?
When collateral is part of a lending agreement, the transaction constitutes secured-lending or asset-based lending.
In typical bank loans such as car loans (for automobile purchase), for instance, the purchased vehicle serves as collateral. When a buyer buys a house or other real estate with a mortgage loan, these serve as collateral for the lender. If the buyer defaults on a mortgage, the lender (for example, a bank) may take ownership of the property through the legal process of foreclosure.
Loans made without collateral are unsecured loans.
- When a bank account holder writes a check that results in an overdraft, which the bank pays, anyway, the account holder's negative balance is considered an unsecured loan by the bank (unless the account holder has funds in other accounts to apply towards the overdraft).
- Student loans are a frequently used form of unsecured lending, where the lender (usually the government) has no direct claim on the borrower's assets in case of default. In some cases, however, the government may eventually withhold certain government funds due to the borrower such as tax refunds, and apply them toward the outstanding student loan principal and interest due.
A surety or guarantee, in finance, is a promise by one party (the guarantor) to assume responsibility for the debt obligation of a borrower if that borrower defaults. The person or company that provides this promise is also known as a suretyor guarantor.