Collateral is an asset or property that a borrower offers to a lender as security for a loan. It serves as a form of protection for the lender. If the borrower fails to pay back the loan, the lender has the right to take possession of the collateral and sell it to recover some or all of their losses.
The type of collateral required depends on the nature of the loan. For example, for a mortgage, the house being purchased often serves as the collateral. For a car loan, the car is the collateral. In business loans, collateral could include inventory, equipment, accounts receivable, or other company assets.
If the value of the collateral falls below the balance of the loan, the borrower may be required to provide additional collateral, known as a margin call in the case of some investments. This can happen, for example, if a borrower’s home significantly decreases in value and the mortgage loan is now greater than the property’s worth.
Similarly, in the case of unsecured loans like a personal loan or a credit card, there’s no collateral involved, but the interest rates are usually higher due to the increased risk to the lender.
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