COLLATERAL FINANCE: Definition, Examples, & Types

Collateral Finance
Photo Credit: National Business Capital

According to Heywood Fleisig; ‘The first question any private lender asks is, “How do I get my money back?” This is a question that is definitely asked by every single lender, as it is important in the business world to have financial security. Collateral is a sure way to greatly reduce the risk for lenders to the barest minimum. It is an asset that has been pledged as insurance protection against credit exposure. When a borrower fails to repay a loan, the lender can seize the property and use the proceeds to recoup their losses. Let’s take a good look at what a collateral finance corporation is and some of its examples

A borrower is someone who takes something from someone else. A lender is someone who gives something to a borrower on the condition that it will be returned. 

What is Collateral?

Collateral is a guarantee that one pledges as their repayment (if they cannot produce the funds they wish to borrow) when they are in need of a loan. It usually is an asset of equal or greater value in relation to the loan.

When you draw up and sign the contract, the collateral inevitably becomes the lender’s security as it would cover the loss of the principal and/or interest. When a borrower defaults on a loan, the lender seizes any security placed to secure the loan.

To put it simply, collateral is something that the lender would take ownership of if the borrower doesn’t pay back the loan. 

Collateral Finance Corporation

A collateral finance corporation is an organization that provides secured loans for individuals or businesses that are in need of them. Unlike banks, finance corporations do not receive cash deposits from borrowers.

The interest rates on these loans, which are usually higher than those charged by banks, are how these companies make money. People usually go to collateral finance corporation(s) when they can’t borrow from banks. They know that if they don’t pay back the loan, they could lose their security.

Examples of Collateral Finance

The following listed below are examples of collateral finance. 

#1. A Car Loan:

For example, if you want to get a loan, you can use a car loan as security. Lenders feel more comfortable loaning money to borrowers when they have some tangible evidence for a refund.

#2. A House Loan:

Common collateral used for a loan is a house. Houses are the primary collateral used to take a mortgage loan. In such a case if a borrower fails to pay their loan within the stipulated time frame, the lender has the right to confiscate the borrower’s house because it is recognized as the lender’s security by both parties (lender and borrower respectively).

A mortgage is a loan that is acquired to purchase a fixed property such as a house, a piece of land, or any property related to real estate. This property must be legally registered and recognized as the property of the borrower. Houses are used as security for mortgage loans, but they can also be used to secure other types of loans. 

#3. A Home Equity Loan:

A home equity loan is a loan that is also referred to as a second mortgage due to similarities. A home equity loan is secured by the home’s equity and allows the borrower to borrow against their equity.

#4. Savings or Investment Accounts:

Another one of the examples of collateral finance examples is savings or investment accounts which are personal assets that can be used as security to take out a loan.

#5. Future Paychecks:

To take short-term loans, a borrower can use future paychecks as security provided that there is assurance attached to the said paycheck. You can use this collateral in case of an emergency and the time frame attached is usually a couple of weeks at most. 

#6. A Vehicle Loan:

In the case of a vehicle loan, if the borrower gets a loan to buy a vehicle (like a car, boat, plane, or motorcycle), the vehicle will serve as security for the loan. In the case of a mortgage, the house would be confiscated by the lender if the borrower fails to pay the loan within the agreed time but in this case, failure to pay the vehicle loan, the lender has the right to the ownership of the vehicle that the borrower took out the loan to purchase.

#7. Jewelries, Stocks and Bonds:

Secured personal loans can be used to pay off credit card debt and the collateral includes; a vehicle, jewelry, stocks and bonds, cash, and so on. 

#8. Assets:

An asset is one of the examples of collateral finance that can become security only when the lender has clearly registered a charge over it, and this can be done by using a floating charge or a fixed charge. Liens are another word for these charges. 

Collateral vs. Lien

Although both terms might look similar, they have notable differences. They work hand in hand but have different meanings.

Definition of Lien

A lien is any charge, interest, or right upon real or personal property to satisfy any debt or responsibility. It can also mean the security interest that comes about because of a mortgage. The real or personal property is the collateral. 

Types of Collateral

There are five (5) major types of collateral. These are;

  1. Equipment such as items used in government or business operations.
  2. Inventory e.g. raw materials. 
  3. Consumer goods e.g. automobiles. 
  4. Farm products e.g. crops and livestock
  5. Property on paper e.g. bonds, stocks, and funds. 

Creditworthiness of Lending

  •  Collateral Value: Collateral value can be related to one; the desirability of the security and two; the monetary value. 
  • Desirability: The desirability of collateral is determined if it is marketable, stable, transferable, and ascertainable. 
  • Marketable: This simply implies that the collateral is traded in real-time has high demand in the market and would appeal to a wide range of audiences if it is to be sold. A great example is stocks and bonds because they are globally recognized and are profitable if managed properly.
  • Stable: Collateral like a stock is highly unstable and this makes it potentially volatile and could put the lender at great risk of loss. Real estate properties on the other hand have relatively higher stability in comparison to stocks. 
  • Transferable: The cost for transferring collateral could be high or the possibility of transfer could be low and it might be difficult to transfer and come with the risk of loss for the lender. On the other hand, real estate property would only cost transfer and re-registration. 
  • Ascertainable: How ascertainable collateral is, can be determined by an appraiser. Stocks might be unstable but are highly ascertainable
  • Monetary Value: Monetary value as the name implies can be self-explanatory but can also mean a handful of things. When figuring out the loan-to-value for a fixed asset (like a house), it is common to use the price of the purchase to value the collateral. The worth of the collateral in this case ultimately determines its value. 

Pros and Cons of Collateral Loans

Using a collateral loan is regarded as secure while using non-collateral loans is deemed unsecured but everything that has an advantage has a disadvantage and could also have risks you should watch out for. 

Pros

  • The borrower has the probability of approval and there is a reduction of risks. 
  • Since the borrower is offering a security to take out a loan, the lender is more likely to provide qualifications to borrow relatively higher funds. 
  • If the borrower has assets that are not very easy to convert to cash, collateral loans have provisions for short-term liquidity. If you have collateral of equal or greater worth, you can borrow money without having to sell your home.

Cons

  • The greatest risk is the loss of the collateral if the borrower is unable to pay the loan. The borrower could lose valuable assets due to failure of repayment within the agreed time frame. 
  • The borrower cannot take out a security loan if he or she does not possess a valuable asset. 

Conclusion

Collateral poses as an assurance or guarantee that the lender will definitely receive the amount of money they lent, even if the borrower does not end up paying. It is advised to collect a collateral loan from a finance corporation that you have a business relationship with because you get a chance to obtain better rates and they are often more inclined to approve the request for the loan. Collateral loans are usually secured and have lower interest rates in comparison to unsecured loans.

Collateral Finance FAQs

What Is Collateral?

Simply put, it is something whose ownership would be transferred to the lender if the borrower fails to produce the loan that was given to him/her.

What is a collateral finance corporation?

It is an organization that provides secured loans for individuals or businesses that are in need of them.

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