What is Collateral? Definition, Meaning, and Example

May 14, 202210 min read
What is Collateral? Definition, Meaning, and Example
Share on facebookShare on TwitterShare on Linkedin

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.  

bar set up meant to highlight how tangible or intagible assets can be considered as part of collateral to lenders

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.

affluent man on laptop meant to showcase an potential investor looking for collateral as part of their due diligence

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.

The other types of collateral, which may be used less frequently, are:

  • Vehicles: In some cases, a vehicle can be used as collateral for a loan. If the borrower defaults, the lender has the right to take possession of the vehicle.
  • Investments: Investment accounts, including stocks and bonds, can be used as collateral. This is often seen in securities-based lending where the borrower can take a loan against the value of their investment portfolio.
  • Insurance Policies: Some insurance policies, such as certain life insurance policies, have a cash value that can be used as collateral for a loan. If the borrower defaults, the lender can claim the cash value of the policy.
  • Intellectual Property: Intellectual property such as patents, trademarks, copyrights, and trade secrets can be used as collateral, especially in businesses that deal with significant intellectual property.
  • Future Cash Flow: In certain business loans, projected future cash flows can be used as a collateral. However, this is riskier for the lender and is usually accompanied by higher interest rates.
  • Personal Guarantees: Although not a physical asset, personal guarantees can also be considered a form of collateral. A personal guarantee is a legal promise made by an individual to repay credit issued to a business for which they serve as an executive or partner. If the business becomes unable to repay the debt, the individual assumes the responsibility of repayment.
  • Collectibles and Art: High-value collectibles, such as art or rare items can be used as collateral for loans, especially from specialized lenders who are equipped to appraise and store these types of items.

man driving a tractor through a fied meant to illustrate how farm equipment is often considered as collateral

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.

Invest in Alternative Assets

Get consistent returns in times of market volatility.

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.

This communication and the information contained in this article are provided for general informational purposes only and should neither be construed nor intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice. Any link to a third-party website (or article contained therein) is not an endorsement, authorization or representation of our affiliation with that third party (or article). We do not exercise control over third-party websites, and we are not responsible or liable for the accuracy, legality, appropriateness, or any other aspect of such website (or article contained therein).

We believe our 10 alternative asset classes, track record across 470+ investments, third party reviews, and history of innovation makes Yieldstreet “The leading platform for private market investing,” as compared to other private market investment platforms.

1 Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. All securities involve risk and may result in significant losses.

3 "Annual interest," "Annualized Return" or "Target Returns" represents a projected annual target rate of interest or annualized target return, and not returns or interest actually obtained by fund investors. “Term" represents the estimated term of the investment; the term of the fund is generally at the discretion of the fund’s manager, and may exceed the estimated term by a significant amount of time. Unless otherwise specified on the fund's offering page, target interest or returns are based on an analysis performed by Yieldstreet of the potential inflows and outflows related to the transactions in which the strategy or fund has engaged and/or is anticipated to engage in over the estimated term of the fund. There is no guarantee that targeted interest or returns will be realized or achieved or that an investment will be successful. Actual performance may deviate from these expectations materially, including due to market or economic factors, portfolio management decisions, modelling error, or other reasons.

4 Reflects the annualized distribution rate that is calculated by taking the most recent quarterly distribution approved by the Fund's Board of Directors and dividing it by prior quarter-end NAV and annualizing it. The Fund’s distribution may exceed its earnings. Therefore, a portion of the Fund’s distribution may be a return of the money you originally invested and represent a return of capital to you for tax purposes.

5 Represents the sum of the interest accrued in the statement period plus the interest paid in the statement period.

6 The internal rate of return ("IRR") represents an average net realized IRR with respect to all matured investments, excluding our Short Term Notes program, weighted by the investment size of each individual investment, made by private investment vehicles managed by YieldStreet Management, LLC from July 1, 2015 through and including July 18th, 2022, after deduction of management fees and all other expenses charged to investments.

7 Investors should carefully consider the investment objectives, risks, charges and expenses of the Yieldstreet Alternative Income Fund before investing. The prospectus for the Yieldstreet Alternative Income Fund contains this and other information about the Fund and can be obtained by emailing [email protected] or by referring to www.yieldstreetalternativeincomefund.com. The prospectus should be read carefully before investing in the Fund. Investments in the Fund are not bank deposits (and thus not insured by the FDIC or by any other federal governmental agency) and are not guaranteed by Yieldstreet or any other party.

8 This tool is for informational purposes only. You should not construe any information provided here as investment advice or a recommendation, endorsement or solicitation to buy any securities offered on Yieldstreet. Yieldstreet is not a fiduciary by virtue of any person's use of or access to this tool. The information provided here is of a general nature and does not address the circumstances of any particular individual or entity. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of this information before making any decisions based on such information.

9 Statistics as of the most recent month end.

300 Park Avenue 15th Floor, New York, NY 10022

844-943-5378

No communication by YieldStreet Inc. or any of its affiliates (collectively, “Yieldstreet™”), through this website or any other medium, should be construed or is intended to be a recommendation to purchase, sell or hold any security or otherwise to be investment, tax, financial, accounting, legal, regulatory or compliance advice, except for specific investment advice that may be provided by YieldStreet Management, LLC pursuant to a written advisory agreement between such entity and the recipient. Nothing on this website is intended as an offer to extend credit, an offer to purchase or sell securities or a solicitation of any securities transaction.

Any financial projections or returns shown on the website are estimated predictions of performance only, are hypothetical, are not based on actual investment results and are not guarantees of future results. Estimated projections do not represent or guarantee the actual results of any transaction, and no representation is made that any transaction will, or is likely to, achieve results or profits similar to those shown. In addition, other financial metrics and calculations shown on the website (including amounts of principal and interest repaid) have not been independently verified or audited and may differ from the actual financial metrics and calculations for any investment, which are contained in the investors’ portfolios. Any investment information contained herein has been secured from sources that Yieldstreet believes are reliable, but we make no representations or warranties as to the accuracy of such information and accept no liability therefore.

Private placement investments are NOT bank deposits (and thus NOT insured by the FDIC or by any other federal governmental agency), are NOT guaranteed by Yieldstreet or any other party, and MAY lose value. Neither the Securities and Exchange Commission nor any federal or state securities commission or regulatory authority has recommended or approved any investment or the accuracy or completeness of any of the information or materials provided by or through the website. Investors must be able to afford the loss of their entire investment.

Investments in private placements are speculative and involve a high degree of risk and those investors who cannot afford to lose their entire investment should not invest. Additionally, investors may receive illiquid and/or restricted securities that may be subject to holding period requirements and/or liquidity concerns. Investments in private placements are highly illiquid and those investors who cannot hold an investment for the long term (at least 5-7 years) should not invest.

Alternative investments should only be part of your overall investment portfolio. Further, the alternative investment portion of your portfolio should include a balanced portfolio of different alternative investments.

Articles or information from third-party media outside of this domain may discuss Yieldstreet or relate to information contained herein, but Yieldstreet does not approve and is not responsible for such content. Hyperlinks to third-party sites, or reproduction of third-party articles, do not constitute an approval or endorsement by Yieldstreet of the linked or reproduced content.

Investing in securities (the "Securities") listed on Yieldstreet™ pose risks, including but not limited to credit risk, interest rate risk, and the risk of losing some or all of the money you invest. Before investing you should: (1) conduct your own investigation and analysis; (2) carefully consider the investment and all related charges, expenses, uncertainties and risks, including all uncertainties and risks described in offering materials; and (3) consult with your own investment, tax, financial and legal advisors. Such Securities are only suitable for accredited investors who understand and are willing and able to accept the high risks associated with private investments.

Investing in private placements requires long-term commitments, the ability to afford to lose the entire investment, and low liquidity needs. This website provides preliminary and general information about the Securities and is intended for initial reference purposes only. It does not summarize or compile all the applicable information. This website does not constitute an offer to sell or buy any securities. No offer or sale of any Securities will occur without the delivery of confidential offering materials and related documents. This information contained herein is qualified by and subject to more detailed information in the applicable offering materials. Yieldstreet™ is not registered as a broker-dealer. Yieldstreet™ does not make any representation or warranty to any prospective investor regarding the legality of an investment in any Yieldstreet Securities.

YieldStreet Inc. is the direct owner of Yieldstreet Management, LLC, which is an SEC-registered investment adviser that manages the Yieldstreet funds and provides investment advice to the Yieldstreet funds, and in certain cases, to retail investors. RealCadre LLC is also indirectly owned by Yieldstreet Inc. RealCadre LLC is a broker-dealer registered with the Securities and Exchange Commission (“SEC”) and a member of the Financial Industry Regulatory Authority (“FINRA”) and the Securities Investor Protection Corporation (“SIPC”). Information on all FINRA registered broker-dealers can be found on FINRA’s BrokerCheck. Despite its affiliation with Yieldstreet Management, LLC, RealCadre LLC has no role in the investment advisory services received by YieldStreet clients or the management or distribution of the Yieldstreet funds or other securities offered on our through Yieldstreet and its personnel. RealCadre LLC does not solicit, sell, recommend, or place interests in the Yieldstreet funds.

Yieldstreet is not a bank. Certain services are offered through Plaid, Orum.io and Footprint and none of such entities is affiliated with Yieldstreet. By using the services offered by any of these entities you acknowledge and accept their respective disclosures and agreements, as applicable.

Investment advisory services are only provided to clients of YieldStreet Management, LLC, an investment advisor registered with the Securities and Exchange Commission, pursuant to a written advisory agreement.

Our site uses a third party service to match browser cookies to your mailing address. We then use another company to send special offers through the mail on our behalf. Our company never receives or stores any of this information and our third parties do not provide or sell this information to any other company or service.

Read full disclosure