Updated on October 4, 2023
The term collateral is used in relation to securing the value of loans disbursed by financial institutions. The meaning of this term and its related details are mentioned below.
Meaning of Collateral
Collateral refers to an asset or property that a borrower pledges to a lender as security for a loan or credit facility. This security acts as a form of assurance for the lender that they will recover their money in case the borrower defaults on the loan. Collateral serves as a way to mitigate the lender’s risk, making it easier for borrowers to access credit and potentially secure loans at better terms, such as lower interest rates.
Types of Collateral
Real Estate – Land, residential or commercial properties, and agricultural land can be used as collateral for loans, such as home loans or business expansion loans.
Gold – Gold ornaments, coins, or bars can be pledged as collateral for gold loans due to their cultural and economic significance in India.
Fixed Deposits – Some banks and financial institutions accept fixed deposits (FDs) as collateral, allowing borrowers to access funds without breaking their investments.
Securities – Stocks, bonds, and other financial securities can serve as collateral for loans or margin trading with stockbrokers.
Vehicles – In auto loans, the financed vehicle itself can act as collateral, enabling lenders to repossess and sell it to recover outstanding amounts in case of default.
Machinery and Equipment – Machinery and equipment can be used as collateral for business loans, particularly for small and medium enterprises (SMEs).
Importance of Collateral
Collateral holds significant importance in the financial system. It serves as a risk mitigation tool for lenders, reducing the potential losses in case of borrower defaults. This in turn often leads to lower interest rates for borrowers. Collateral also broadens access to credit, particularly for individuals with weaker credit histories. The use of collateral influences the loan amount and repayment duration based on collateral value as well as enables access to a diverse range of loan products tailored to varying needs, from home loans to personal and business loans.