What is Collateralization
Collateralization occurs when a borrower pledges an asset as recourse to the lender in the event that the borrower defaults on the initial loan. Collateralization of assets gives lenders a sufficient level of reassurance against default risk. It may also help a borrower receive a loan for which he was unable to obtain with less than optimal credit history.
BREAKING DOWN Collateralization
Collateralization can be involved with a variety of different types of loans. Some of the most common types of collateral used in collateralized loans include real estate, automobiles, art, jewelry and securities.
Collateralized loans are also known as secured loans. These loans are secured against property which the lender has the right to if the borrower defaults. The principal amount offered in a collateralized loan is typically based on the appraised collateral value of the property. Most secured lenders will loan approximately 70% to 90% of the value of the property to the borrower.
Mortgage financing is one type of loan secured with a title. A borrower is approved for a mortgage loan and must make regular principal and interest payments over the life of the loan. The lender holds the title to the property and remains the owner until the mortgage loan is paid in full. If the borrower reports delinquent payments and is unable to repay the loan, the lender keeps the title and forecloses. With a mortgage title loan the lender can resell the home to mitigate from lost value through the charge-off.
Businesses often structure the use of collateral in their credit lending deals. Businesses can use all types of collateral for debt offerings. Bonds for example may include terms to specific secured assets as collateral such as equipment and/or property. This collateral is pledged for the repayment of the bond offering in the event of default. If the borrower defaults the underwriters on the deal can seize the collateral property for repayment to investors. The increased level of security offered to a bondholder typically helps to lower the coupon rate offered on the bond which can decrease the cost of financing for the issuer.
Securities as Collateral
Using securities as collateral is also common in investing. This type of collateral use is regulated by government legislations and primarily overseen by the Federal Reserve. Many brokerage firms offer margin borrowing which allows an investor to obtain a loan with securities in their account as collateral. Generally when margin is issued to a borrower all of the securities in their account may be considered collateral. Often brokerages will not allow margin borrowing until an account reaches a certain limit such as approximately $2,000. With securities as collateral, the brokerage has the right to sell securities in an account to meet their specified requirements. Typically margin calls are a percentage of the total amount borrowed. Therefore if you borrowed $1,000 the brokerage would require that the securities you present as collateral maintain 25% or $250 of the value borrowed. Thus, its essential that the investments made with margin increase in value for a positive return.