What is collateral?
Not to be confused with the Tom Cruise film of the same name, collateral is property or other assets pledged to a lender to help you secure a loan. When you borrow money, you agree that your lender can take something from you if you fail to repay the debt. This is known as a secured loan.
Where have you heard about collateral?
A familiar example of collateral in everyday life is when you take out a mortgage to buy a house. The property acts as collateral. If you fail to pay back the loan under the terms of your mortgage agreement, your lender can take possession of your home.
What you need to know about collateral...
Collateral acts as security for lenders, so this type of loan often has better interest rates than unsecured loans as there's less risk involved. If you borrow money with a credit card, there isn't any collateral, so the interest rate is likely to be significantly higher than with a mortgage or personal loan.
In margin trading the investor borrows part of the sum needed to buy shares from the broker that is handling the transaction. The investor uses the securities in their brokerage account as collateral in case of a margin call. The broker can liquidate the investor's securities to meet the maintenance margin if the investor is unable to deposit the required funds in time.
There are 5 main types of collateral – consumer goods, business equipment, farm products, inventory and stocks and bonds. Many new businesses are also required to pledge collateral because they don’t have a proven track record of making a profit.