Loan Collateral: Here’s a Detailed Insight into Collateral Meaning and Financing

Anyone familiar with the word ‘loan’ would know what collateral means. In simple words, collateral is an asset you pledge with the lender for lending funds. In case, the borrower fails to repay the loan on time, the lender can seize the asset and sell it to recoup the loss. Collateral loans are quite popular among individuals seeking funds for both—personal and professional needs. It offers a convenient loan option to individuals with assets as they can leverage its inherent value to avail a loan against collateral.

Besides opening doors to secured loans, collateral loans also create a financial responsibility for the borrower and motivate them to be committed towards monthly repayment. If you are wondering what is collateral and how it works, then look no further. Here’s all you need to know—the meaning of collateral, its uses and how it can help you avail a secured loan.
 

Meaning and Scope of Collateral

The term ‘collateral’ implies an asset that financial institutions require from a borrower to cover the risk of lending money. A loan with collateral, thus, implies a financial arrangement wherein the borrower needs to provide an eligible fixed or floating asset as security to avail loan.

The asset acts as a guarantee for loan recovery and covers any risk in case the borrower fails to repay the loan liability in part or in full. Collateral can vary depending on the type of loan. For example, for business loan collateral, you may need to provide a business asset as a security. Similarly, for personal loan collateral, you may need to provide a personal asset such as a residential property, commercial property, gold, or vehicle as security.

The scope of collateral usually extends across the types of financing needed and collateral arrangement agreed upon. Simultaneously, you need to provide related loan collateral documents to establish ownership and avail funding.

Also Read: 4 popular FAQs on collateral and small business loans
 

Types of Collateral

Here’s a list of common assets most lenders accept as collateral for secured loan financing:
 

• Real estate (residential or commercial property) – Any property owned by an individual, whether residential or commercial, can serve as collateral for availing funds.


• Plant and machinery – It is a business asset and can be used as collateral to fund business needs.


• Vehicle – Vehicles such as car, two-wheeler or any other commercial vehicle are also accepted as collateral to provide certain types of loans. In this case, the title of such a vehicle remains with the lender until the total repayment of the loan is done.


• Gold – Gold or any other valuable jewellery is also considered as collateral for personal or business financing.


• Financial securities – Financial securities such as bonds and shares serve as collateral while seeking a secured loan.


• Unpaid invoices – Businesses can also leverage their unpaid invoices as collateral to avail secured loans.


 

Some Examples of Collateral loans

Collateral is an umbrella term that encompasses different types of loans based on the arrangement agreed between a financial institution and a borrower. Here are some prominent collateral arrangements under which lenders provide financing:
 

• Mortgage

  Under a mortgage lending arrangement, the collateral is always a fixed asset such as land, building, plant, machinery fixed to the ground etc. Home loans and loans against property are some of the most common examples of mortgage financing.
   

• Pledge

  Under a pledge arrangement, financing is provided based on the contract affected with an agreed asset’s ownership handed over as a guarantee to secured funding. Gold loan is an example of financing under pledge. Non-payment of the loan liability under pledge results in forfeiture of the asset.
   

• Hypothecation

  Although similar to pledge, hypothecation is a collateral financing arrangement wherein the actual possession, title or ownership rights remain with the borrower. Financing is facilitated under an agreement of property title and possession forfeiture in case of repayment default. Car loans and two-wheeler loans are some common examples of financing through hypothecation.
   

• Invoice collateral

  As the name suggests, it typically refers to a financing arrangement wherein a business’s unpaid invoices are provided as collateral. Small to medium businesses usually secure working capital funding through invoice financing and invoice discounting under this secured loan arrangement.
  
  Collateral loan interest rates usually vary with the type of collateral arrangement agreed upon between the lender and borrower. Alternatively, if an individual or business lacks the necessary asset to provide as collateral, they can opt for collateral-free loans available against different eligibility requirements.

Also Read: A Complete Guide to Collateral Free Business Loans
 

Collateral Financing – How Does It Work?

Under a collateral financing arrangement, a borrower applies for the selected loan with an asset as collateral. While applying for the loan, the borrower needs to provide the necessary property documents to prove ownership. Based on the current market value of the property, the lender approves the secured loan as a percentage of the value. Once disbursed, the borrower needs to repay it in EMIs payable throughout the selected tenure.

In case of a long-standing default of such payment, or where a borrower declares incapacity for repayment, the asset is forfeited and auctioned for loan liability recovery.
Contrarily, on successful repayment of the total loan liability, the lender releases the asset and provides a NOC certifying return of encumbrance-free ownership of the asset.
 

Pros and Cons of Collateral Loans

Despite being a popular financing arrangement, collateral loans come with their set of advantages and disadvantages.
 
Pros
 

1. A collateral loan is easy to avail as it requires only an asset as security and other eligibility requirements are kept at a minimum.
2. It also comes with an attractive rate of interest, usually lower than unsecured loans.
3. Usually, a collateral loan is also available in high quantum due to its reduced risk.
4. It is also a long-term loan and helps in building credit score over time.

 
Cons
 

1. Its application process is usually lengthy and involves paperwork, thus extending the time taken for processing.
2. It also puts the borrower’s asset provided as collateral at risk.

 

Key considerations in collateral loans

 

Asset condition

The condition of the assets is an important consideration in collateral loan approval. 
If the loan is secured by real estate, the property's condition, location, and circle rate are all taken into account. When applying for a used car loan, the resale value, manufacturing year, make & model and insurance coverage are all taken into account.
 

Ownership

If the collateral is commercial property, ownership is extremely vital. If the property in question has multiple owners and you are the only one applying for a mortgage, the lender will not approve a collateral loan. In this case, you must obtain a no-objection certificate signed by all of the other owners; then only the lender will process your application.
 

Time to maturity

This is relevant if you are pledging your investment document. For example, if you apply for a secured loan with a repayment term of 60 months, but the investment in question is due to mature in the next twelve months, your lender may reject your application.
 

Purity

The concept of purity applies to gold loans. Gold jewellery with purity ranging from 10 carats to 22 carats is available on the market. 24-carat gold is only available in bars. Most lenders will approve a loan against jewellery if the purity is 22 carat or higher.

Also Read: Business Loan without Collateral: What are the Pros and Cons

Your decision regarding availing a collateral loan must depend on your financing needs and the benefits that you will get with it. Choose a collateral loan as per your funding requirement and make sure to assess your repayment capacity before applying for one.

Disclaimer: This post was first published on 13th May 2021 and has been updated for the latest information, freshness and accuracy.