What you need to know about collateral

When approaching lenders for a loan, having collateral has proven to have a higher loan acceptance rate than not having any collateral at all. Collateral not only allows individuals and businesses to borrow money easily, but it also has non-financial leverages that can be used.

The term collateral is used loosely in many fields; it is helpful to understand the meaning of a subject before discussing it. Let us first define collateral before explaining how it works and the different types of collateral to be aware of.

What is a Collateral?

Collateral is an asset that a borrower offers to a lender as security for a loan. Collateral can take many forms, including real estate, stocks, and other assets deemed valuable by a lender in order to secure a loan. The borrower and the lender reach an agreement in which the borrower pledges his or her asset(s) to the lender in order to secure a loan.

If the borrower fails to repay the loan in accordance with the loan agreement, the borrower will forfeit the asset to the lender. The lender then has the right to seize the borrower’s asset and sell it in order to recoup some or all of the transaction’s losses.

Characteristics of a Collateral

• A collateral must be an asset with a monetary value.
• The borrower keeps the asset(s) used as collateral and continues to use it, only forfeiting it to the lender if he/she fails to make the agreed-upon payments.
• When taking out a loan, collateral is required to secure the loan in the event that the borrower fails to make a repayment.
• Lower interest rates are more likely to be granted to someone who uses his or her asset as collateral.
• Assets used as collateral may be forfeited to the lender if the borrower fails to make agreed-upon payments.

How does a Collateral Work?

When lending money to individuals or businesses, lenders may require some form of security. When applying for a business or personal loan, lenders may request collateral due to economic, social, or political factors. If the borrower fails to make a repayment, the lender wants to ensure that they get something out of the loan.

Before a loan can be granted to a borrower, a lender will require an asset to be pledged as collateral. The lender will want the asset(s) in order to reduce the risk of issuing a loan. The borrower will also bear the risk of taking out such a loan in the event that he or she fails to make repayments and their assets will be seized. The borrower will then be forced to meet the financial obligations that have been established.

Collateral has evolved over time and now comes in a variety of forms. Today, one can obtain a loan without pledging any assets; rather, the collateral, in this case, will be expected future income. For example, the borrower can take out a loan of R100,000.00 repayable in 12 months with R20,000.00 and not put down any deposit; however, the borrower’s salary will be used as collateral, and R10,000.00 will be deducted from his/her account on a monthly basis.

Other forms of collateral include the purchase of a car or a home. Nowadays, it is extremely unlikely for a bank to request assets as collateral. However, pledging collateral over a loan can result in lower interest rates and better repayment terms.

Types of Collateral

Lenders in South Africa accept a variety of collateral types. Acceptance of Collateral is dependent on the type of guarantee issued against the loan. The following are some examples of acceptable collateral:

• A vehicle as collateral is one type of collateral that is commonly used in South Africa. When purchasing a car on credit, the lender retains ownership of the vehicle until the loan is fully paid off.

• Property: Property is typically used when a borrower requires a large sum of money and is regarded as one of the most rewarding types of collateral in South Africa.

• Portfolio Investments: Company stock can be used as collateral, and company owners can use their stake in a company for financial leverage. The Memorandum of Incorporation of some companies prohibits such behavior by owners.

• Inventory: Businesses that trade goods can use their inventory to secure loans. The loan amount will be determined by the amount of inventory held and the intended use of the funds.

• Valuable Items: As collateral, valuable items are popular with microlenders. Companies that accept valuable items as collateral include cash crusaders and cash converters.

Advantages

• It makes credit more accessible, especially for those with a shaky credit history.
• When a loan is secured by collateral, interest rates are typically reduced.
• If collateral is presented, the lender will not require a downpayment on a loan.
• In some cases, the borrower may be able to obtain a larger loan.
• Borrowers with bad credit may be able to obtain a loan if they have collateral.

Disadvantages

• Failure to repay a loan on time will result in the loss of an asset that has been put as a collateral.
• The application process for collateralized loans can be more complicated than for unsecured loans.
• The lender may impose restrictions on the borrower’s use of the funds provided.

Conclusion

Collateral is an asset that can be used for financial gains without losing that asset if the requirements of a loan agreement are met. Take caution when taking out loans that require collateral, and only take out loans that you can truly afford, as you may lose your asset.