Collateral
Collateral is an item of value, such as a property, that a borrower puts forward as a means of securing a loan from a lender. The item can be seized by the lender if the borrower fails to repay the loan according to the terms which have been agreed. Therefore, collateral is a way in which a lender can acquire some security against the capital that they loan.
The lender’s claim to a borrower’s collateral is described as a 'lien'.
For the loan to be considered 'secure', the collateral’s value must equal or exceed the amount remaining on loan. Loans that are secured by collateral typically have lower interest rates than unsecured loans. This is because they are less risky for the lenders, as the borrower has a strong incentive to continue payment and losses can be recovered.
A mortgage is a common type of collateral. The mortgage lender (typically a bank) will usually require that the home being purchased is provided as collateral. If mortgage loan repayments are not made according to the agreed terms, the bank is entitled to take ownership of the home (described as foreclosure), which it can then sell as a means of recouping losses.
NB: In construction, the term 'collateral warranty' refers to an agreement associated with another 'primary' contract providing for a duty of care to be extended by one of the contracting parties to a third party who is not party to the original contract. See Collateral warranties for more information.
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