How does collateral work
Every lender faces risk of not getting their money back. The interest paid on the capital is one of the costs of this risk. That's why, if the borrower can make lender feel more secure, the interest rate my be lower. In order to do this lenders usually need a collateral.
Collaterization of a loan means, that the borrower pledges some kind of property to the lender in order to secure the repayment of the loan. Usually, the property still stays by the borrower and the borrower remains its owner. However, if the borrower fails to pay the installments on the loan, the lender will have the right to take this property and sell it in order to get the money back.
Most common example of collateral is a real estate in mortgage loans. The borrower buys a house with the borrowed money and the house belongs to him. However, the house is a collateral for the bank (lender) and secures the mortgage loan. The mortgage agreement expires only after all the capital and interest is paid off - then the lender loses his potential rights to the house. This kind of collateralization is often called hypothecation.
Another popular example is a car loan (also called "auto loan"). Borrower buys the car and the car serves as the collateral. Of course the borrower must insure the car in case of an accident or theft, and cease the rights from the insurance to the lender.
In other types of loans, there may be some different types of collaterals. Any property can be useful here. For example, financial assets (stocks, bonds, etc.) often can serve to secure the loans. These are often assets that have limited liquidity (you can't
sell them very fast), but their value is high.
It is important to note, that the lender can use the collateral only to regain the money owed by the borrower (capital and interest). If the property (real estate, car) will be sold, the lender will get only the sum owed to him by the borrower. The rest will go to the borrower, who was previously the owner of this property. For example - if you owe $1 mln to the bank and your house secures the loan, and you are not able to pay the installments any more, the bank can take over the house and sell it. But, if the house will be sold for $1.5 mln, the bank will take only $1 mln and the rest ($0.5 mln) will come back to you.
We said in the beginning that the interest rate is the cost of risk. It is obvious, that the interest rate is lower when a collateral exists. The second important remark is that the lower is the amount of loan in relation to the value of the collateral, the lower should be the interest rate. For example - if you get $1 mln loan and secure it with a house worth $2 mln, you will get better lending condition than a person securing such a loan with a house worth $1 mln. In the latter case, the risk to the bank is much higher, because there is no free space left for risk of market changes (in times of crisis value of the house can drop and the collateral will not secure the loan in 100%).
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