Updated July 13, 2023
What is Collateralization?
The term “collateralization” originates from the word “collateral,” which refers to the security offered by the borrower against a loan in the banking industry. Thus, “collateralization” denotes using valuable assets to secure a loan.
In case of a loan default by a borrower, the lender may confiscate the assets and sell them off to repay the loan entirely or at least cover the loss. Collateral-backed loans provide a sufficient level of assurance to the lenders against default risk while it helps the borrowers get loans at competitive interest rates despite poor credit histories. As a result, collateralized loans are usually available at a substantially lower interest rate than unsecured loans.
How Does Collateralization Work?
In many cases, banks are reluctant to lend unsecured loans to borrowers despite their excellent credit ratings. The reason behind the action is the fear of losing the entire money if the borrowers default on the loans. Although the banks can sue the borrowers and drag them to court, they seldom intend to follow this lengthy and expensive process of court cases. Thus, the banks prefer to lend money to those borrowers who can offer adequate collateral cover.
In a collateralized loan, if the borrower defaults, the lender has the right to take possession of the collateral and sell it off to recover its outstanding balance. In this way, collateralization gives a sense of security to the lender. Thus, collateralized loans are available at a better interest rate than unsecured loans as the lender assumes the lower risk in the former. The collateral can be real estate property, a car, financial instruments, cash, or even objects such as jewelry, art, etc. In addition, businesses sometimes pledge their equity capital or receivables collateral for business loans.
Examples of Collateralization
Let us look at some examples to understand the concept of collateral in more detail.
Let us assume that David is planning to purchase a real estate property worth $1,500,000, and he intends to apply for a loan. Accordingly, he approached ABC Bank for the loan and offered to provide the real estate property as collateral.
Generally, banks follow a maximum loan-to-value (LTV) ratio, which means that the loan amount can’t exceed a certain percentage (as per the LTV ratio) of the asset value. For example, ABC Bank has a maximum LTV ratio of 70%.
As per ABC Bank’s maximum LTV ratio, the maximum amount that the bank can lend David as a loan for property purchase is 70% of the value of real estate property, i.e., $1,050,000 (= 70% * $1,500,000).
Let us look at how collateralization utilizes in investing, where securities are often used as collateral. For example, margin buying refers to investment with borrowed money while using the other securities in the borrower’s account as collateral. Typically, the collateral offered for the loan is known as a margin call, a certain percentage of the total borrowed money.
Let us assume that John borrowed $5,000 for margin trading, and the brokerage charges 20% of the loan as collateral. So, John has to offer securities worth $1,000 (=20% * $5,000) as collateral for the loan. In this case, John must earn enough profit from the investments to at least cover the loan’s interest rate.
There are instances where collateral for one obligation is used as collateral for another, known as cross-collateralization. This often occurs in real estate-related transactions, where the same house offers as collateral for more than one mortgage.
Let us assume Steven decided to create a second mortgage on his house that is already under one mortgage. The second mortgage would use Steven’s existing equity in the house as collateral. However, the issue is that in case of default, even on the second mortgage, Steven would risk foreclosure on his house.
Collateralization vs Securitization
Below are the differences:
|Definition||It refers to the use of valuable assets for securing a loan.||It refers to collating or grouping some illiquid assets through financial engineering and transforming them into newer saleable securities.|
|Ease to recover||If the case of a loan default, it is easy to recover as a specific asset owned by the borrower is the security for the loan.||It is synthesized from a bundle of mortgages using an extremely convoluted process. In the case of a default, it is very difficult to identify the assets for recovery.|
|Parties involved||Two parties are involved in the process – the borrower and the lender.||Besides the borrower and the lender, trust involves who created the complex securities. Therefore, the agreement that binds all the parties is very complicated.|
|Investment||The lender invests in a single asset or borrower.||The lender invests in a diversified portfolio of assets.|
Some of the key takeaways of the article are:
- Collateralization is the process of using valuable assets to secure a loan, which provides a sense of security to the lender against the risk of loan default.
- As the lender assumes the lower risk in a collateralized loan, the interest rate charged by a bank on this type of loan is substantially lower than an unsecured loan.
- If the borrower defaults on a collateralized loan, the lender can confiscate the collateral and sell it off to recover the loan’s outstanding balance.
So, it can be seen that collateralization is a mechanism of offering assets to the lender to secure a loan. These collaterals usually provide access to loans in a fast and secure way. Therefore, the process of collateralization is beneficial for both borrowers and lenders.
This is a guide to Collateralization. Here we also discuss the definition and working of Collateralization and different examples. You may also have a look at the following articles to learn more –