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Collateral

Understand the Definition of Collateral and the Different Types of Collateral Pledged in Loan Agreements

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Collateral

In This Article
  • What is collateral?
  • What are some common examples of collateral?
  • Why do loan agreements often require collateral?
  • Which type of lenders typically request collateral being pledged?

Collateral Definition

For a borrower’s request for a loan to be approved, a lender often requires collateral as part of the deal.

More specifically, tangible assets with high liquidity are typically preferred as collateral by lenders.

If the lender has a claim on the borrower’s collateral (i.e. a “lien”), then the loan is called a secured loan, as the financing is collateral-backed.

If the borrower defaults on the financial obligation – i.e. the borrower is unable to service interest expense payments or meet mandatory principal amortization payments on time – then the lender has the right to seize the pledged collateral.

Examples of Collateral

Type of Loan Collateral
Corporate Loan
  • Cash and Equivalents (e.g. Money Market Account, Certificate of Deposit, or “CD”)
  • Accounts Receivable (A/R)
  • Inventory
  • Property, Plant & Equipment (PP&E)
Residential Mortgages
  • Real Estate (i.e. Home Equity Loans)
Automobiles (Auto Loan)
  • Vehicle Purchased
Securities-Based Lending
  • Cash – Often Forced Liquidation of Positions
  • Outside Capital
Margin Loans
  • Investments (e.g. Stocks) Purchased on Margin

Collateral Incentives – Simple Example

Let’s say that a customer at a restaurant has forgotten his wallet and realized his mistake when it came time to pay for the consumed meal.

Convincing the restaurant owner/staff to allow him to drive back home to retrieve his wallet would likely be met with distrust (i.e. “dine and dash”) unless he left a valuable belonging such as a watch behind.

The fact that the customer left a belonging with value – a watch with both personal value and market value – serves as evidence that he most likely intends to come back.

In the case that the customer never returns, then the restaurant is in possession of the watch, which the restaurant would now technically own.

Collateral in Loan Agreements

Collateral serves as evidence that a borrower intends to repay their debt obligations as outlined in the loan agreement, which minimizes the risk to the lender.

Unless the provider of the debt is a distressed fund seeking majority control in anticipation of default, most lenders request collateral for the following reasons:

  • Ensure the Borrower is Incentivized to Avoid Default
  • Limit the Maximum Potential Loss of Capital

A company that has defaulted and fallen into financial distress can enter a time-consuming restructuring process, which both the borrower and lender would want to avoid, if possible.

Collateral Pros/Cons

By requiring collateral for the loan agreement to close, the lender – typically a risk-averse, senior lender like a bank – can further protect their downside risk (i.e. the total amount of capital that could be lost in a worst-case scenario).

However, pledging the rights to property and assets of value does not just help the loan approval process.

In fact, the borrower will often benefit from lower interest rates and more favorable lending terms for collateral-backed, secured loans, which is why secured senior debt is well-known for carrying low-interest rates (i.e. being a “cheaper” source of debt capital compared to bonds and mezzanine financing).

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