Collateral refers to the different kinds of assets that borrowers pledge as security for a loan.
The use of collateral reduces repayment risk for the lender. If the borrower cannot pay a debt on time and goes into default, the lender can then sell off the collateral to recover some or all of their money. As a result, loans secured with collateral—called secured loans—typically have better payment terms and lower interest rates than unsecured loans.
Different types of collateral are used for different types of loans:
- Operating loans used to cover day-to-day expenses often use inventory and accounts receivable as collateral.
- Demand loans (for which the lender can demand payment at any time) are often secured by vehicles and equipment.
- Term loans with set repayment schedules often rely on land and buildings for collateral (commercial or residential).
Once a loan is completely repaid, the lender no longer has any claim on the collateral.
More about collateral
Lenders prefer liquid collateral, such as marketable securities–treasury bills, stocks, bonds, mutual funds and exchange traded funds (ETFs). This is because they can convert it into cash more easily if necessary. Loans secured by highly liquid assets tend to have higher loan-to-value (LTV) ratios, lower interest rates and more flexible repayment terms.
Banks will be willing to take more risk if the collateral is very liquid. For example: A lender may grant up to 90% of the face value of a highly marketable security, 75% for residential real estate and 60% for commercial real estate.