The word collateralization originates from the word Collateral, which means security (asset) is offered against the loan availed by the borrower providing reassurance to the lender on the recoverability of the amount lent. If the borrower defaults on the repayment of a loan, the lender has the right to recover his loan from the security collateralized with him. In this process, an asset is pledged with the lender who has a charge on the same and it acts like a recourse in the event of default by the borrower.
There are various types of assets that could be used as collateral, such as Jewellery, Immovable property, vehicles, inventories, etc.
How does Loan Collaterals Work in banks?
Generally, banks and other financial institutions have a maximum suggested loan to value ratio, which implies that the maximum loan amount cannot, in any case, exceed a specific % of asset value. This can be better explained with the help of the following example:
BoA Bank has a maximum loan to value ratioLoan To Value RatioThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value. of 80% and Ms. Susan owns a property at Fame street, New York, which has a market value of US$ 800,000 and she has approached BoA to obtain a loan for her new business venture and has offered to provide the said property as a mortgage.
As per the maximum loan to value ratio fixed by the bank, Ms. Susan can avail of a maximum loan of $720,000.
Types of Loan Collateralization
As collateralization is a mechanism to secure the loan offered by the lender, it can be used for various types of loan facilities, that are offered by the bank or financial institutions. Some types of loan for which collateralization can be used are as under:
#1 – Mortgage Loans
A mortgage loan refers to the loan availed against the title of the property. A mortgage loan involves regular payment of interest as well as principal.
The title of the property mortgaged against the loan remains with the lender till the time loan has been repaid by the borrower, post which the title gets transferred to the borrower. In case the borrower defaults in repayment of the principal amount or interest thereon, the lender can sell the mortgaged property to recover the amount due to him.
#2 – Business Loans
There are various types of loans that a business avails, such as a bank overdraftBank OverdraftOverdraft is a banking facility that offers short-term credit to the account holders by allowing them to withdraw money from their savings or current account even if their account balance is or below zero. Its authorized limit differs from customer to customer., term loans, issuance of bonds, etc collaterals are often used in most of the business loans. Business loans can have all kinds of assets as collateral, for example, a loan availed for purchase of equipment by a hospital can have the equipment so purchased as a mortgaged with the bank. It is pledged to provide security to the lender, that his amount would be repaid and in case of default by the borrower, the lender has the right to recover the amount due, through the sale of equipment so mortgaged.
Similarly, bonds or debenturesBonds Or DebenturesBonds and debentures are both fixed-interest debt instruments. Bonds are generally secured by collateral, have lower interest rates, and are issued by both companies and the government. Debentures are raised for long-term financing and are normally issued by public companies only. issued by the company might have a charge on the specific immovable property of the company, that can be sold by the subscribers of these instruments, in case of default in repayment of principal or interest thereon, by the company.
#3 – Investor Loans
Many times brokerage firms allow investors to obtain loans against the securities held by them. Investors who don’t have sufficient funds in the account and wish to trade on the margin allowed by the brokerage firms can avail the margin on the basis of the value of the securities held in their account.
The amount of margin allowed is usually multiple times of the value of securities held in the account and such a margin is allowed only for a short duration of time, after which, it needs to be settled either through the sale of securities purchased or through adding more funds to the accounts.
Collateralization is a mechanism of securing loans by offering assets to the borrower as collateral. Such collaterals usually provide a way faster and secure access to loans. Banks and financial institutions look at maximum loan to value ratio before releasing the loans to individuals or businesses.
This has been a guide to Collateralization and its meaning. Here we discuss types of assets and loans used in Collateral including Mortgage, Business loans, etc. You can learn more about financing from the following articles –