What is Collateral?
You've probably heard about collateral before - especially since it's one of the buzzwords in the financial realm. However, do you really know what it means and how it can impact your borrowing decisions? Let's start at the beginning and define collateral in layman's terms. Collateral is something pledged as security for repayment of a loan, to be forfeited in the event of a default. If you're still a little confused, that's ok. Let's break it down further.
Collateral acts as a security measure for a loan, so if you fail to make your payments on the time, the lender can seize your property. Collateral often comes in the form of a personal asset such as a car or house. Think about it - if you agree to put your vehicle on the line, the lender is more willing to extend a loan to you, because he or she knows they have something to fall back on if the deal falls through. It's helpful to think of synonyms of collateral, such as "security," "guarantee," and "insurance." When you pledge an asset, you tell the lender you plan to uphold your end of the bargain and pay in a timely manner.
Repossession, Foreclosure: Failing to Repay a Debt
If the borrower fails to pay the principal and interest under the terms of a loan obligation, the borrower forfeits the property pledged as collateral. As seen in recent years during the housing crisis, many people's homes went into foreclosure, because they defaulted on their mortgage loan obligation. However, defaulting on a collateral-based loan transaction does not always result in losing something as major as your place of residence.
A pawn shop is a simple and common example of a business that accepts a wide range of items rather than strictly dealing with cash. When you take your grandmother's gold jewelry to the pawn shop, you get a sum of money based on the value of the items. Once you have paid your debt to the pawnbroker, he or she will return your jewelry. However, if you fail to pay, the pawnbroker will keep your items and sell them in his or her store.
Flexibility of Loan Approval and Terms
Collateral is traditionally associated with secured lending or asset-based lending. Since you are pledging a personal item or piece of property, you will typically enjoy more flexibility when it comes to interest rates and payment plans. As mentioned before, the lender already has a guarantee in place, so there is less of a need to be rigid when it comes to other aspects of the loan. Taking out a loan secured by collateral can be a smart move - as long as you stay on top of your payments and uphold your end of the agreement.