What is Collateral? Definition, Meaning, and Example

Curious about what collateral is and how it is defined? It’s a good question. You are probably aware that pledging collateral can help borrowers get better rates when they are trying to take out loans. Here, we’ve consolidated some information that you should know to understand what collateral is and how it plays a role in a loan, whether for the borrower or the lender. We also provide a definition and meaning for collateral by explaining how it works with an example. 

The idea of offering up something of value to convince a lender in order to borrow money is a fundamental concept in finance. The practice goes back as far as ancient civilizations like those in Greece, Rome, and India. As this concept is fundamental to asset-backed lending, a thorough understanding of how collateral works is necessary for those interested in investments that are secured by collateral. 

What is collateral?

The simple definition of collateral is that it’s a tangible or intangible asset that a borrower pledges to a lender to secure a loan. If a borrower defaults in their obligations to the secured lender under the loan documents, the secured lender can exercise remedies to foreclose on the collateral and try to sell it to recover the loan amount.

What are the benefits of collateral to lenders?

Taking collateral as security for a loan can help reduce the risk of default for a lender who can foreclose against the collateral in the event of a borrower default. However, building collateral into a loan structure does not fully mitigate the risk of non-payment for lenders. Collateral can lose value, and secured creditors can have competing claims on the same collateral, and foreclosing against collateral can take time and money or be delayed if the borrower files for bankruptcy.  

What is collateral in the real world?

Now that you have a better understanding of what collateral is, let’s take a look at a basic example of how collateral works in the real world. 

Tired of working in the solar panel industry, Owen decides to follow his dream of opening a bar in the heart of the Mission District in San Francisco. Say for example, that the property Owen wishes to purchase to open the bar costs $100,000, but he can only afford to put up $30,000 of his own money, and opts to borrow the remaining $70,000 from the bank. 

In order for the bank to lend Owen such a large amount relative to the value of the real estate, the bank needs a way to protect itself in case Owen can’t pay back the loan. As a result, the bank requires him to pledge the bar real estate as collateral for the loan. After considering the terms, Owen decides to take the leap and agrees. 

The first few months go well with the new venture, but slowly business starts to slip. Owen starts finding it difficult to make ends meet. Eventually, Owen is unable to make the monthly loan payments to the bank. When Owen ends up defaulting on the loan, the bank takes control of the bar property. The bank then forecloses against the bar real estate and tries to resell it in an attempt to recoup the proceeds of the loan. 

If the scenario were to play out differently with Owen being able to make the monthly payments, he would eventually be able to pay off the loan while fulfilling his dream of running a successful bar in the heart of the Mission District in San Francisco.

Types of collateral

Depending on the type of loan, collateral can be diverse and may include assets such as property, equipment, and inventory. While there are alternative forms of collateral, the following are some of the typical asset classes used as collateral.

• Borrower’s savings account: A borrower may be willing to put up their savings account which is a kind of personal asset as collateral when taking a personal loan. 
  
• Inventory: When inventory is used as collateral, it falls in the realm of inventory financing. This is when a company acquires a line of credit for a short term loan so it can purchase products that serve as collateral for the loan to be sold later. 
  
• Accounts receivable: This is when the invoices that will be paid within 30 to 60 days are used as collateral to secure typically short-term loans. Lenders consider accounts receivable as solid collateral because of their liquidity. 
  
• Real estate: Real estate is considered solid collateral because it is often of high value. Different types of collateral can be used to secure an investor’s principal balance.
  
• Equipment: Using equipment as collateral is called asset-based equipment financing. This is a strategy that can be used by companies as a fast way to obtain capital based on the collateral that they already own and want to either refinance or buy with a significant down payment.
  
• Cash: Borrowers often pledge cash to secure a loan. This typically takes the form of a down payment to ensure the borrower has a financial stake in the loan transaction. This cash will be forfeited in the event of a default — along with the tangible item against which the loan was issued in many cases. Cash can also be used as an asset to back a loan in the conventional sense. In other words, the borrower can agree to hand over a certain amount of cash if the terms of the loan cannot be met.
  
• Crypto: Substituting digital assets such as Bitcoin or Ethereum for tangible ones, crypto-backed loans are secured by a borrower’s promise to forfeit those digital assets in the event they cannot repay the loan as agreed. Crypto-backed loans have emerged as cryptocurrencies have gained traction. The advantage for the borrower here is the assets can still be used to generate gains, even as they secure the loan. However, because the value of crypto fluctuates, borrowers can be called upon to up their pledges if the value of the collateralized assets drops.

Collateral for small business loans

When a borrower applies for a small business loan, the lender may ask the borrower to pledge business assets, such as inventory and/or accounts receivable. If the aggregate appraised value of the inventory and accounts receivable is less than the value of the loan, a lender may also ask for other assets, such as real estate or cash, as security for the loan. Eligible assets are often determined by the type and terms of the loan, along with the lender’s underwriting requirements. 

Collateral in finance

Collateral is the basis of asset-based finance. In addition to the common asset classes mentioned above, collateral can also be pledged in different forms for alternative investment offerings. In litigation finance, for example, collateral can take the form of claims on future proceeds from a settled or pre-settled case, while in real estate a property or building itself can serve as the collateral. 

Collateral and interest rates

Structuring a loan as a secured loan reduces repayment risk for lenders. Naturally, if there is collateral involved, the risk associated with the loan is significantly mitigated and so will have lower interest rates. Unsecured loans tend to carry higher interest rates than secured loans as the non-payment risk to lenders is greater when there is no collateral pledged as security.

Evaluating collateral

Any asset being used as collateral must be carefully evaluated by the lender when deciding on the loan amount and their underwriting requirements. While there are a variety of variables that lenders consider when granting a loan, two important factors are loan-to-value ratio (LTV) and debt service coverage ratio (DSCR).

• LTV: LTV is the ratio of the loan amount to the appraised value of the underlying asset pledged as collateral for the loan. In the example above, assuming the appraised value of the bar property is $100,000, the LTV would be $70,000 (the amount of the loan)/$100,000 (the appraised value of the bar property), or 0.7. To reduce risk, lenders may prefer to underwrite loans that have a low LTV ratio, and therefore indicate a greater possibility that the proceeds of the sale of the pledged assets would cover the amount of the loan in the event of foreclosure.  
  
• DSCR (debt service coverage ratio): DSCR is a ratio measuring the cash flow available to service debt and is calculated by dividing a business’ net operating income by its outstanding debt obligations. A higher ratio indicates a more creditworthy borrower and is an indication that the borrower is more likely to have sufficient funds to repay its loan.  
  
• Debt yield ratio: This ratio is used by lenders to understand how long it would take for them to regain their investment if they had to repossess the collateral if the loan were to default. The debt yield ratio is calculated by taking the net operating income (NOI) and dividing it by the debt (loan) amount, times 100%. NOI is the revenue from the investment minus operating expenses. 

Collateral is the basis of asset-based secured lending. Securing a loan with collateral helps to reduce the risk for lenders and can help borrowers qualify for loans with lower interest rates. There are a variety of common and alternative assets that can be used as collateral, the sufficiency of which will be determined by a lender’s underwriting criteria.

Collateral in Economics

A fundamental building block of financial markets, collateral has the ability to influence economic growth as well as financial stability. The protection it can provide  to lenders, and the ability it may afford borrowers to get larger loans at more favorable interest rates, play a significant role in the functioning of economies. Institutions supporting trading, payments, clearing, and settlement depend heavily upon collateral to operate.

Cash Secured Loan

Useful as a credit-building tool, cash-secured loans can help borrowers who are either just starting out and establishing their credit ratings, or those who are trying to recover from a credit setback. With a cash secured loan, the borrower is pledging the cash they have in a bank account in exchange for the trust of a lender. In most cases, the amount of the loan will directly correlate to the amount of cash the borrower has on deposit. Should the borrower prove unable to repay the loan, the lender will seize the funds in the account.

Unsecured Loans

 These instruments are issued against a borrower’s promise to repay. Credit cards and personal loans fall into this category, as do revolving charge accounts with department stores and most government-backed student loans. In this instance, the primary consequence of a default is a negative entry on the borrower’s credit report. This will have an adverse effect on their ability to secure future financing of any type. 

Collateral vs Security

While collateral is often referred to as serving as security for a loan, it helps to understand how security works. Borrowers grant lenders a security interest in an asset in what’s known as a secured transaction. Basically, the pledged collateral is the security for the loan. In order for a security interest to be legally valid, the Uniform Commercial Code requires it to meet three criteria. The security interest is assigned a verifiable value; the borrower must own the pledged asset and the borrower must sign a security agreement. Intangible items such as patents or debts owed to the borrower may also back security agreements.

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