What is "Collateral?"
Banks and other financial services providers know that lending brings a certain level of risk for the lender. There is always a non-zero probability that the borrower will not repay on time or even default entirely. Collateral is the lender's "Insurance" against these outcomes. Having a guarantor is another form of lender-protection against default.
Lenders and borrowers sometimes refer to loan surety, equivalently, to a guarantor for a loan. Both terms refer to a person who takes legal responsibility for providing payment if the borrower defaults and does not or cannot provide the agreed collateral.
Guarantors are in some cases known as sponsors or co-signers. Guarantors can be involved with secured loans and unsecured loans, alike.
Explaining Collateral in Context
Sections below further describes collateral in context with lending-related terms including:
- What is "Collateral?"
- Collateral in the Loan Contract secured lending.
- Familiar Forms of Unsecured Loans.
Neither lender nor borrower should sign a written loan contract that does not answer these questions clearly and unambiguously.
- What is the nature and identity of the collateral?
- Who owns the collateral asset during life of the loan?
- What exactly are the conditions constitute default?
The contract identifies a specific item or property as collateral. For vehicles or machinery assets, for instance, this means specifying the make, model, year, unique serial number, and in some cases, ownership history.
When valuables such as works of art, antiques, or jewelry serve as collateral, the loan contract will include description and valuation estimates from professional appraisers.
Collateral Ownership During Loan Life
The loan contract must specify who owns the collateral during the life of the loan—borrower or lender. This is necessary because default, by definition occurs during loan life, and the contract must describe the lender's remedy,
- With standard secured bank loans for vehicles, boats, or aircraft, the purchase item itself serves as collateral.
When buying a house or other real estate with a mortgage loan, these properties become the collateral.
In these cases, the lender has legal title to the collateral starting from the moment of purchase. Ownership of the title or deed transfers to the buyer only when the buyer pays off the loan as the contract specifies.
When buyers default on these loans, lenders need only retain title and take physical possession of assets they already own. With automobiles, this process is repossession, and with real estate mortgages in default, the process is foreclosure.
- With loans for other purposes, lenders are free to designate any property of verifiable value owned by the buyer or guarantor as collateral.
Conditions for Default
Loan agreements of all kinds specify clearly the mandatory payment terms, including payment due dates, time allowances and fees for late payment, if any, and the number of payments the borrower can miss, if any, before the lender can declare default.
Borrowers who are having trouble making payments normally contact the lender before default occurs, and attempt to re-negotiate loan terms that will enable them to retain use of the collateral and avoid default.
Loans made without collateral are unsecured loans.
- When a bank account holder writes a check that results in an overdraft, and when the bank pays, anyway, the account holder's negative balance is an unsecure loan by the bank (unless the account holder has funds in other accounts to apply towards the overdraft).
- Student loans are a common form of unsecure 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.