Collateral

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Definition of Collateral:

Collateral is an asset that is pledged to secure a loan.

Detailed Explanation:

When making a loan, bankers frequently require collateral to reduce their risk. If payments are not made in a timely manner, the lender can legally force the sale of the collateral to repay the loan. Understandably, bankers believe that there is a greater probability that borrowers will repay a loan if they risk losing the secured asset. An unsecured loan is a loan without collateral. Unsecured loans normally carry a higher interest rate because they have a greater risk of not being paid in a timely manner. 

Theoretically, any asset can be used as collateral. The most commonly used assets include: real estate, vehicles, equipment, or securities such as stock. For example, assume that James wants to purchase a $200,000 home. He uses $40,000 of his savings for a down payment and borrows the remaining $160,000 using a mortgage. A mortgage is a loan using real estate as collateral. The bank places a lien on the property, which means that James cannot sell his home unless he pays off the mortgage. The bank is protected. It has collateral valued at $200,000 protecting a $160,000 loan. If James fails to make timely payments, it can foreclose on the property, which means the bank can sell James's home to pay off the loan. If James chooses to move and sell his home, the bank is protected by its lien and the loan balance would be paid from the proceeds of the sale. 

Normally the asset being purchased is used as collateral. A car loan is used to purchase the vehicle that is used as collateral. An equipment loan is used to purchase equipment. However, this is not required. Home equity loans are mortgages that are commonly used to consolidate bills or purchase other items because borrowers want to take advantage of a lower interest rate and better terms than if they had used an unsecured loan. Margin loans are secured by stock and are typically used to purchase other shares. The brokerage firm may have a margin call and force the sale of the collateral if the value of the stock used as collateral drops enough. 

A credit card is the most common type of unsecured loan, which is why a credit card usually carries a higher interest rate than other less risky loans. The lender cannot force the borrower to sell an asset to pay off the credit card. Instead a lender may "warn" other lenders by reporting late payments to a credit bureau. Poor credit ratings adversely affect a borrower's ability to borrow money. The borrower may not be able to find a lender willing to lend the money, or if one does, it will probably charge a higher interest rate.

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