Collateral refers to any asset that is pledged to the bank by the borrower when taking out a loan; which the bank uses to recover losses in the event that the borrower defaults on his loan. Collateral can refer to any type of asset with value such as land, buildings (houses), cars, equipment, or even securities. Securities such as stocks, treasury bills, notes, and exchange traded funds can also be pledged as collateral when taking out loans. The following article explains collateral in general and shows how securities can be used as collateral for borrowing. The article will also highlight the differences and similarities between the two concepts.
What is Collateral?
When a loan is taken out, an individual is making a commitment to repay the loan by its maturity and to make interest payments on the principal amount of the loan. However, there is no assurance for the bank that the borrower will repay his loan at all. Due to this uncertainty, the bank must take out some form of an ‘assurance’ so that they will not suffer losses in the event that the borrower defaults on his loan. In order to minimize losses, banks require collateral for the loan. The collateral can be any asset that has a value equivalent to or higher than the amount of the loan taken out. The borrower will have to pledge the asset as collateral to the bank when the loan is taken out. In case if the borrower defaults from making loan repayments the lender can seize the asset, sell it, and recover their losses.
What is Security?
Securities refer to a broad set of financial assets such as bank notes, bonds, stocks, futures, forwards, options, swaps, etc. There are special types of loans that can be taken out by pledging securities as collateral; this is referred to as securities based lending. In securities based lending scenario, the borrower will pledge his securities portfolio, and will be able to access funding while leaving the securities trading in the market. In most instances, the borrower will be able to obtain interest, dividends, and will be able to benefit from any capital gains. A portfolio of securities is subject to fluctuation in value (in response to market changes), and in the event that the portfolio value falls, the lender may ask the borrower for additional collateral. In the event that the borrower defaults on the loan the lender can sell the securities and recover losses.
Collateral vs Security
Collateral is the ‘insurance’ policy for the lender; an asset that is pledged to the bank by the borrower when taking out a loan. As explained in the article there are different types of collateral such as property, equipment, cars, and even a securities portfolio can be pledged as security. Similarities between pledging assets and securities as collateral are that while borrowing funds, the borrower can continue reaping the benefits of both, using assets and holding securities.
The main difference between pledging other assets and securities as collateral is that since securities have fluctuating value (as opposed to more stable assets such as land, housing, etc.) the lender may be at higher risk if the portfolio starts to lose value.
Summary:
• Collateral refers to any asset that is pledged to the bank by the borrower when taking out a loan; which the bank uses to recover losses in the event that the borrower defaults on his loan.
• There are special types of loans that can be taken out by pledging securities as collateral; this is referred to as securities based lending, where the borrower will pledge his securities portfolio to obtain funding.
• A portfolio of securities is subject to fluctuation in value (in response to market changes), and in the event that the portfolio value falls, the lender may ask the borrower for additional collateral.