Collateral is the asset that you pledge to obtain a secured loan from the lender. It safeguards the lender from any possible defaults by the borrower and lowers the overall risk of lending. Let us learn more about collateral loans below.
What is a collateral loan?
These are secured loans offered by lenders to borrowers who pledge specific assets as collateral. They are different from unsecured loans where you do not have to pledge anything to obtain the funds. So, the collateral loan meaning works out to a specific type of loan offered by banks or NBFCs (non banking financial companies) where you have to pledge any asset to obtain the necessary loan amount.
An example would be a home loan that you’re taking from a financial institution. In this case, the property itself is the collateral and is mortgaged to the lender until you repay the loan amount in full. It reduces the lender’s risk in case you default on the loan. The asset can be liquidated or sold to recover the pending dues in any such situation.
How Does Collateral Work in Loans?
Here is how collateral works in loans:
- You apply for the loan by meeting the lender’s terms and condition and offer an asset as collateral.
- This is taken by the lender as the guarantee for sanctioning the loan.
- In case you default on the loan and are unable to repay, the lender may legally take possession of the pledged collateral.
- It may be liquidated to recover the lender’s pending dues in such situations.
Many borrowers often fail to repay their loans despite having good CIBIL scores. Hence, the collateral is what protects the interest of the lender. It is mostly mortgaged or pledged in the lender’s name and you can release it once you repay the entire outstanding loan amount.
What are the types of Collateral Loans?
There are various types of collateral loans that you can avail from lenders. Some of them include:
- Loan against property- This loan is secured by immovable assets like commercial or residential buildings, apartments, individual homes, and industrial units. These loans come with extended repayment tenures, mostly up to 15 years and you may get loans up to 65% of the net worth of the property.
- Gold Loans- Lenders evaluate the weight and purity of the gold that you’re willing to pledge before sanctioning the loan. However, in case the market price of gold comes down significantly, you may have to pay an additional margin amount. The loan amount may also differ from your expectations, based on fluctuations in the market.
- Vehicle Loans- You can apply for two and four-wheeler loans, where the vehicle itself stands as collateral. These loans usually have repayment periods between 36-84 months, depending on the lender’s policies. The vehicle remains under the ownership of the lender until the loan is fully repaid.
- Loans against securities/Investement- You can also obtain funds by pledging your investments like Stock, Corporate bonds & debentures, Govt. savings schemes, ETFs, Government bonds, fixed deposits, mutual funds, and cash-value life insurance policies.
- Equipment finance- Business owners often apply for loans by pledging their equipment or machinery as security until the loan is repaid. It is commonly seen in sectors like manufacturing and construction.
- Home loans- You may take a home loan from a lender and the property will be pledged as collateral until you repay the outstanding amount. These loans come with longer tenures between 10-30 years on average.
Read more: What is Loan Against Mutual Funds?
Examples of Collateral in Real Life
There are several collateral examples in banking and finance. For example, you may apply for a home loan or car loan, where the underlying collateral is the property or vehicle that you buy. These are assets that have resale value and you will have to transfer possession to the lender until you repay the loan. Some other examples include gold coins, bars, jewellery, and sometimes other valuables like fine art and antiques.
Land or other properties may also be pledged to obtain funds. You may also pledge your mutual fund units as collateral or life insurance policies with cash value. Other examples of collateral in this category include bonds, stocks, and even sovereign gold bonds. You may also pledge fixed deposits to obtain funds.
Pros and Cons of Collateral Loans
Here are some of the pros and cons of collateral loans.
Pros:
- Quicker loan access- You can easily qualify for loans, particularly in case of bigger amounts.
- Lower interest rates- Secured loans often come with lower interest rates due to the lower risk of the lender.
- Better loan terms- The collateral makes it possible to get longer repayment periods or other favorable terms from the lender.
- Helpful for those with lower credit scores- If you have a lower CIBIL score or limited/negligible credit history, the collateral loan may be a helpful option.
- Flexible usage- Collateral loans, especially those against property or gold, come with flexible end-usage provisions. You can use the funds for various purposes without having to explain the same to the lender.
Cons:
- Risk of loss- The biggest disadvantage of collateral loans is that you risk losing your pledged asset in case you fail to repay the loan in the future.
- Longer qualification times- Sometimes it may be hard to estimate the right value of the collateral. This may prolong the approval process.
- Credit score issues- Defaulting on a secured loan can significantly damage your credit Score, and the negative impact may remain for up to seven years
Is Collateral Always Property?
No, collateral does not always mean property. It can be diverse kinds of assets, ranging from vehicles and stocks to fixed deposits, gold, equipment/machinery, insurance policies, bonds, accounts receivable, and other valuables.
What Loans Do Not Require Collateral?
Unsecured loans like personal loans do not need any collateral. However, they come with higher rates of interest due to the increased risk borne by the lender. They are more flexible in terms of end-usage and come with fixed repayment terms.
Do I Get My Collateral Back After Loan Repayment?
Yes, you will get back your collateral after you repay the outstanding loan amount. The lender will release the claim over the asset, often by removing the lien on the same. You will have to get the no-dues certificate from the lender which confirms the full repayment of the loan and your legal ownership over the asset.
In the case of real estate, you may have to visit the registrar’s office to get the lien removed officially. You have to collect all the original documents of the collateral and its ownership details from the lender thereafter.
What are the Importance of Collateral for Borrowers and Lenders?
Collateral is important for both lenders and borrowers. It is what enables more security for a loan as far as lenders are concerned, while borrowers can use it to get funds for various needs. Let’s look at the importance of the same for both parties.
Importance of Collateral for Lenders:
- Mitigating risks- Collateral functions like a safety net, enabling lenders to recover their losses in case of any loan defaults.
- Higher confidence- When the loan is guaranteed by an asset, lenders feel more confident about lending a certain amount to the borrower. This is especially true in the case of new borrowers or those without an established credit history.
- Lower losses- The ability to recover funds through collateral considerably lowers the overall risk exposure of the lender.
Importance of Collateral for Borrowers:
- Access to higher credit- Collateral makes it more convenient for borrowers to qualify for loans that they would not have got otherwise.
- Favorable loan terms- Borrowers can get higher amounts at lower interest rates and more favorable repayment terms in comparison to unsecured loans.
- Seamless loan approval- For people with limited credit history or business entities, collateral can be a key factor that guarantees loan approval.
- Quicker disbursal- Secured loans with collateral are often processed and disbursed swiftly.
- Tapping assets to fund various needs- Collateral makes it possible for borrowers to tap their current assets like real estate and investments to get funds for varying needs. From business expansion to urgent expenses, they can be met by leveraging assets strategically.
Collateral vs Security: Is There a Difference?
Understanding both sides of the collateral vs. security debate is crucial. Here are some key pointers that apply to both these terms.
Security:
- It is a broader term that covers guarantees or assets given to lenders.
- It can encompass multiple kinds of assets like primary security (main asset that the loan purchases or directly linked to the project of the borrower).
- There may also be collateral as a specific type of security that is pledged as an asset to secure loans from the lender whenever the primary security is insufficient.
- It works as an additional layer of security for the lender.
- Security also includes personal guarantees of individuals to repay loans in case the primary borrower defaults.
Collateral:
- It is a secondary asset like property, jewellery, stocks, etc. pledged by borrowers as added safety nets for loans.
- Collateral works as a buffer for the lender and enables the entity to recover losses in case the primary security is insufficient.
So, as you can see, all collateral is security but not all security is collateral. That is the key difference worth understanding between these two concepts.
Conclusion
Collateral is thus an important component of any secured loan, be it a house, investment, vehicle, or other asset. It is what lowers the lender’s risks, while enabling borrowers to tap assets to get better interest rates and loan terms. However, you should keep potential default risks in mind before applying for these loans.
