What is Collateralization?
Collateralization describes the process in which a loan agreement is secured by a borrower from pledging an asset as collateral. In the event that the borrower defaults, i.e. is unable to service a periodic interest expense payment or mandatory debt repayment per the lending agreement schedule, the lender has the right to seize the collateral.
How Collateralization Works (Step-by-Step)
Collateralization refers to a financing arrangement wherein a borrower is able to secure a loan by offering collateral to de-risk the lending agreement. Otherwise, the borrower would have been unlikely to obtain the loan or would have received more unfavorable terms.
Collateralization tends to reduce the interest expense charged by lenders since their risk is lowered by the pledged collateral.
Hypothetically, if the borrower were to default on the loan, the lender has a legal claim on the collateral and can sell it to recoup the outstanding balance of the loan (and recover a portion or the entirety of the original loan amount).
How Collateralization Impacts Lender Interest Rates
Senior lenders such as corporate banks are far more likely to require collateral as part of the lending agreement, which is the reason the interest rates charged also tend to be lower than yield-oriented lenders such as issuers of high-yield bonds.
- Secured Loan → Lower Interest Rates
- Unsecured Loan → Higher Interest Rates
Because the risk associated with unsecured loans (i.e. subordinated debt) is substantially higher relative to secured loans (i.e. senior debt), the lenders are placed lower in the capital structure and are not protected by any collateral.
In effect, unsecured lenders charge significantly higher interest rates to compensate for the increased risk undertaken by providing financing to the borrower.
In many instances, the lender might demand collateral due to the borrower’s lackluster credit history and risk of default, such as a limited credit history or poor credit score. But in other cases, the lender might be risk-averse and request collateral in exchange for a lower yield, as capital preservation is the lender’s priority rather than achieving the highest yield possible.
Types of Collateralized Loans: Home Mortgages and Auto Loans
The term “collateral” applies to not only corporate borrowers but also consumers. For example, mortgages and auto loans are two of the most common types of secured loans.
If the consumer defaults on the outstanding loan, the lender can seize the house (or real estate property) in a mortgage or the underlying car or automotive asset for the auto loan.
While no borrower wants to risk losing possession of their assets, offering collateral as part of a lending agreement is often a last resort and the only method to obtain the asset in question, e.g. the purchase of the home.
On the other hand, lenders desire protection against the risk of default, which is inevitable because unexpected circumstances can occur, whether from a personal matter (e.g. a job loss or a family member passing away) or more related to the economy (i.e. a recession).
With that said, collateralized loans represent a middle-ground resolution that enables the borrower and lender to arrive at an amicable transaction.
Cross Collateralization: Collateral Structured Lending Example
Generally speaking, most lenders only accept assets that are easy to liquidate as collateral.
If the asset’s value is difficult to determine and the demand in the market is questionable, the lender might struggle to sell the collateral and be forced to sell at a steep discount. That would defeat the original intent of the collateral in the first place, which is to serve as protection from incurring monetary losses.
The most common examples of collateral are the following types of assets:
The fact that the asset is valuable to the borrower by itself is insufficient. Rather, the asset pledged as collateral must be marketable to a broad range of potential buyers and not lose much of its original value if it were to be sold.
The collateral demanded and provided as part of the loan agreement is a matter of negotiation between the borrower and the lender, but liquid assets tend to be preferred in close to all transactions.
In certain cases, the collateral pledged in one agreement can also be used as collateral for another obligation, which is referred to as cross-collateralization.
Such arrangements are most common in the real estate sector, where a property can be pledged as collateral for more than one mortgage, i.e. the same piece of collateral is utilized to secure multiple loans, or a mixture of assets is pledged in combination to make the loan less risky.