What Is Collateralization?
Collateralization is the use of a valuable asset to secure a loan. If the borrower defaults on the loan, the lender may seize the asset and sell it to offset the loss.
Collateralization of assets gives lenders a sufficient level of reassurance against default risk. It also helps some borrowers obtain loans if they have poor credit histories. Collateralized loans generally have a substantially lower interest rate than unsecured loans.
A home mortgage and a car loan are two common examples of collateralization. The house or the car may be seized by the lender if the borrower defaults on the payments.
Collateralization is common for business loans. A business owner may put up equipment, property, stock, or bonds as security for a loan needed to expand or improve the business.
- Collateralization provides a lender with security against default on a loan.
- Because it greatly reduces the lender's risk, the interest rates on collateralized loans are substantially lower.
- Businesses typically use collateralized loans to fund expansion and improvement projects.
The principal amount available in a collateralized loan is typically based on the appraised collateral value of the property. Most secured lenders will loan about 70% to 90% of the value of the collateral.
Collateralized loans are inherently safer than non-collateralized loans, and therefore generally have lower interest rates. Non-collateralized, or unsecured, loans include credit cards and personal loans.
For example, compare these rates as of March 2020 for collateralized and unsecured loans:
- An auto loan could be obtained at an interest rate of about 5% by an applicant with a good credit rating;
- A 30-year fixed-rate mortgage could be obtained for an interest rate of about 3.6%.
- The average credit card interest rate was 21.28%.
- Personal loan rates from banks ranged from about 5% all the way up to 36%.
Collateralized Business Loans
Companies often attach collateral to bonds when they issue them. The bonds can be secured with a variety of assets such as equipment and property.
Buying on margin is a type of collateralized lending used by active investors. The collateral consists of assets in the investor's account.
This collateral is pledged for the repayment of the bond offering in the event of the company's default. If the borrower defaults, the underwriters of the deal can seize the property, sell it, and use the proceeds to repay investors.
The increased level of security offered to a bondholder typically helps to lower the interest rate offered on the bond, which decreases the cost of financing for the issuer.
Using securities as collateral is common in investing. Margin buying, which means buying in part with borrowed money, is based on the use of collateral, which consists of other securities in the borrower's account.
If the investor has sufficient assets in the account, a brokerage firm will allow that investor to buy securities with borrowed money, using the assets in the account as collateral. The loan will be repaid from the profits of the purchase, assuming it's successful. If it loses money, the borrower must repay the loan with a new deposit or a sale of assets in the account.
Typically, margin calls are for a percentage of the total amount borrowed. If an investor borrows $1,000, the brokerage would require that 25% of the loan, or $250, be available as collateral. Thus, it's essential that the investments made with margin increase in value for a positive return.