Financial lending transactions use collateral to add an extra layer of security for lending companies. If you are ever involved in any situation involving large-scale loans, it is essential to have a good understanding of what it is and how it works in general.
Collateral Explained and Clarified
Collateral is property or another asset with value that a borrower will offer to a lender to secure a loan. The lender can seize the collateral if the borrower defaults on their payments, allowing the lender to recoup their losses. In most cases, these assets remain in place until the borrower fully repays the loan.
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What is a Pledging Collateral?
Pledging collateral means the borrower will come up with an asset that has a certain amount of value to qualify. For example, if the loan requires $25,000 in collateral, a vehicle worth $10,000 would not be sufficient. The other thing to keep in mind is that assets lose value over time, so the value of the asset may be more at the beginning of the loan than at the end of the loan. But, since the outstanding loan amount decreases over time as well, this may work out. The banker will evaluate each situation on a case by case basis.
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Who Pledges Collateral?
Pledging collateral is the term for putting up assets to secure a loan. Bankers and lenders consider several factors to see if a borrower qualifies for a loan, even if they have pledged assets. If a borrower has very poor credit, he or she is considered high risk by bankers. In such cases, the individual's assets must have enough value to offset their poor credit score.
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Pledging Securities
Securities are stocks and other investments traded on the stock market. The borrower can use these assets as collateral to secure a loan. Securities increase and decrease in value each day based on how the stock market is performing in general. Despite this, securities may be accepted because they are liquid assets that convert to cash quickly.
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What Securities Can Serve as Collateral?
There are three primary types of securities: equity securities, debt securities, and derivatives securities. Equity securities involve stocks a company sold in exchange for part ownership or an equity share into the business. Debt securities is another term for bonds. Derivative securities relate to the value of stocks, bonds, or other forms of assets.
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What is Considered Good Collateral?
Ideal assets for pledging are those with a longer life cycle -- those that are durable and can withstand normal wear and tear to maintain their value. Assets with an identification number are also valuable. For example a residential property, commercial property, or automobiles.
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Types of Collateral
Typically, anything of value can be used if approved and accepted by the lender. In addition to those noted previously, the most common are property, cash, inventory financing, accounts receivables, and blanket liens. The lender decides based on their policies and determines which form of is best for the lending transaction and other factors.
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Why Lenders Require it
When banks and other lenders put up money to finance a business, a lot is at stake, and they are the ones taking the risk. However, by giving up their assets, the borrower ensures that both parties assume some risks It shows the borrower's willingness to share the risk as a good-faith gesture. If a borrower defaults on their loan, the lender can then seize the pledged assets to make up for their losses. Handing over assets proves to the lender that the borrower is sincerely interested in repaying the loan.
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Collateral Documents Used in a Loan
Collateral documents or security documents secure the borrower's obligation within the loan agreement. Lenders may prepare different forms of collateral documents depending on the type of asset. Documents may include the security and pledge agreements, collateral agency agreements, and collateral assignments.
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Using Personal Guarantees
A personal guarantee is a promise to repay a business loan. When a business does not qualify for a loan with its current credit history, the lender generally requires a personal guarantor, usually the CEO or an executive of the business in question. This individual's personal credit and assets are on the line for the business loan, and he or she is accountable if the business defaults on payments.
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