Collateral

November 21, 2023 - Around 3 mins mins to read

Collateral is an essential term in today’s financial world.

Collateral refers to any asset used as security when obtaining a loan. The purpose of collateral is to ensure that the borrower will either repay the loan to retrieve the collateral or that the lender will have an equivalent value to the borrowed sum. The specifics of how collateral functions depend on the agreement between the lender and borrower.

Property is one of the most commonly used forms of collateral. For example, when you take out a mortgage, the property you are purchasing serves as collateral. The bank grants you a loan with the condition that if you fail to repay your debt, the bank will assume ownership of the property. This type of collateral is often referred to as a collateralized mortgage obligation (CMO).

While mortgages are the most popular form of collateral agreements, any other asset can be considered collateral if agreed upon by the lender. For instance, you can borrow money using your car, a specific amount of gold or silver, or even your watch as collateral. Depending on the lender and the type of loan you require, collateral can encompass almost anything with monetary value.

The primary purpose of collateral is to minimize risk for the lender as much as possible. Taking collateral provides the lender with assurance that even if the borrower defaults on their loan, the lender will not be left empty-handed. Typically, banks can offer credit lines to customers without collateral for smaller loan amounts. However, when the loan request exceeds a certain threshold, the bank usually requires some form of collateral.

It is important to note that loans backed by collateral generally offer significantly better interest rates. By offering additional assurance to the lender that the loan will be repaid, collateralized loans traditionally come with lower interest rates. This is one of the reasons why collateral-based loans have gained popularity over time. While the borrower must forfeit the collateral if they default on the loan, the total amount they have to repay is reduced. Considering this, many borrowers prefer to provide collateral to minimize the additional costs associated with high interest rates.

In the realm of cryptocurrency, collateralization is also gaining traction with the introduction of collateral tokens. Collateral tokens serve a similar purpose to those in traditional financial markets, acting as a risk mitigator for lenders in the crypto space. As cryptocurrency loans become more prevalent and individuals turn to blockchain for financial management, collateral tokens are increasingly in demand.