Most individuals and businesses avail different types of loans for meeting their fund requirements. People often take loans for buying a home or car.
Moreover, they may avail of personal finance to pay for holidays, weddings, or other requirements.
On the other hand, businesses avail of loans for meeting their working capital, equipment purchase, inventory building, and other requirements.
Loans can either be secured or unsecured. The former is secured against certain assets like the home or car purchased using the money.
The latter is provided without any security, and therefore, it is a riskier option for the loan providers.
What is collateral?
Collaterals are some types of assets accepted by lenders and act as security for the borrowed amount. Some common types of assets include real estate, investments, gold, vehicles, and much more.
These assets provide security to the lenders against potential defaults. If the borrower defaults on the repayment, the lender can repossess the security and can sell it to partially or completely recover the outstanding dues.
How collateral works
Before sanctioning your loan application, the financial institution evaluates your repayment capabilities. Therefore, they require some form of security, which reduces their risks.
The security can be repossessed and sold by the lender if you default on the loan repayment. The possible loss of your asset ensures you repay the loan on time.
The nature of the loan determines what is the collateral. For example, if you take out a home loan, the security will be the property.
Similarly, the car is the security when you avail of a vehicle loan. Moreover, other types of borrowings can be secured against various assets.
Examples of collateral
Residential mortgage
This is a type of loan where your house is used as secured collateral. If you default on the equated monthly installment (EMI) for a particular period, the lender can take legal action to repossess your property. They may then sell the house to recover their dues.
Home equity loans
Similar to a home loan, equity loans convert the property’s equity into cash. A fixed-rate loan offers a fixed amount, which is paid in EMIs. The interest rate is fixed during the entire loan tenure.
Home Equity Line of Credit (HELOC) approves a certain amount based on the equity available in your property. This money can then be withdrawn as needed. Moreover, the monthly installment varies on the withdrawn amount and rate of interest.
Loan against property (LAP)
You may borrow money against an existing property and use it for any purpose. The lender creates a lien on the property to recover losses in case of default. LAP is similar to a regular mortgage loan.
However, the former restricts the use of the borrowed amount to purchase or construct a new home.
Automobile loans
You may avail of such loans when you buy a new car or other vehicles, which can be used for any purpose.
However, commercial vehicle loans cannot be used for personal use, and you must have an existing business to avail of this facility. Lenders also provide vehicle loans on used automobiles.
Loan against securities
Loans against securities are extended overdraft facilities offered by financial institutions. You may use your investments in shares, mutual funds, fixed deposits, bonds, and much more as financial collateral to avail of a credit limit.
Generally, loans against securities are short-term credit facilities.
Business loans
Lenders accept different types of assets like plant and machinery, business property, investments, accounts receivable, insurance policies, and much more to offer loans to business owners.
Different types of collateral
The types of collateral generally depend on the kind of loan applied for. Some of the commonly accepted assets are as follows:
Property
Home loans, LAP, and home equity loans are secured against real estate. It can also be used to avail of business or secured personal finance.
The lender creates a lien on the property while offering such loans.
Investments
Also known as security-based lending or stock-based lending, you may use your investments to borrow money from financial institutions. Some of the eligible financial instruments include shares, bonds, fixed deposits, mutual funds, and much more.
However, if the value of these investments falls below the outstanding loan amount, the lender will ask for additional security.
Cars and other vehicles
When you avail of an automobile loan, the vehicle is used as security. You may also apply for a loan on an owned car to meet fund requirements.
In both these situations, the lenders will hold the title to your vehicle until the loan amount is fully repaid.
Cash
You can use the balance in your savings account to apply for a loan. Lenders also offer loans against certificates of deposits (CDs) and money market accounts.
The maximum limit or borrowed amount is limited to the value of the security.
Other valuable assets
Some lenders may accept valuables like art and collectibles, jewelry, and more as security.
Businesses may also avail of loans against inventories. However, these assets are appraised by an empaneled appraiser to determine their value.
Advantages of collateral loans
Offering some assets as security while applying for a loan has several advantages, such as the following.
- Helps enhance your eligibility even if you have a limited credit history or a lower credit score.
- You may be able to borrow a higher amount or be eligible for a larger line of credit when compared to unsecured facilities.
- Repayment of secured loans on time helps improve your credit score, and new borrowers can build their credit history.
- Compared to unsecured loans, secured limits often have a lower rate of interest.
Disadvantages of collateral loans
Before you opt for a collateral loan, here are some of its possible disadvantages you must consider.
- You may lose your asset if you are unable to repay the amount on time and default on your debt.
- Generally, the end-use of the borrowed amount is restricted (in the case of home loans where the money must be used to purchase or construct a house).
- The procedure may be more cumbersome and longer than unsecured loans since the lenders may appraise the value of the asset before approving your application.
How to use collateral for small business loans?
If you are a small business owner and want to apply for a loan, you may use your business assets as security. These can include accounts receivable or inventory.
However, if the total appraised value of inventory and receivables is less than the loan amount, you may need to offer other assets like cash or real estate to secure the loan.
The types of assets that are eligible for small business loans depend on the lenders’ underwriting requirements and the type of loan applied for.
Tips to get a loan without collateral
For several types of loans like mortgage finance or automobile loans, providing security is necessary. Nonetheless, it is possible to get a loan without any security.
Most lenders provide unsecured personal finance and credit card loans. If you are a long-time customer with a disciplined repayment record and high creditworthiness, financial institutions may provide competitive interest rates on unsecured finance.
Moreover, while sanctioning an unsecured loan, lenders consider your income, expenses, employment stability, and cash flows to determine your financial stability and loan eligibility.
What does collateral mean in finance?
Collateralization means asset-based financing. In addition to the aforementioned assets, security can be in other forms for alternative investment options.
For example, in litigation finance, security can be in the form of claims on the future proceeds from a pre-settled or settled case.
Similarly, a building or another real estate property can serve as collateral for availing of a loan.
Collateral and interest rates
When you offer security against the borrowed amount, it reduces the risk for the lenders.
This is because, in case you default on the repayment, the lender can take possession of the security and sell it to recoup the loss.
Therefore, the rate of interest on secured loans is often lower when compared to unsecured loans, which carry a higher risk for the lenders.
The fundamental principle of asset-based lending is offering some security while applying for a loan.
Securing the loan with an asset reduces the lenders’ risks as they create a lien on the secured asset. Additionally, it allows you to borrow money at a lower rate of interest, which reduces your total cash outflow over the duration of the loan.
Several types of common and alternative assets are used as collateral and their adequacy is determined by the appraisers’ values and the underwriting norms of the lenders.
Secured loans can either be used to purchase the particular asset where the financial institution retains ownership until the amount is repaid. Alternatively, you may pledge an already owned asset to borrow money within the pre-determined loan tenure.
This is a companion discussion topic for the original entry at https://jupiter.money/resources/understanding-collateral/