Updated: Mar 24, 2022, 11:06am
The process of lending inherently involves taking on a degree of risk on the part of the lender. This is because there is a chance that the capital loaned out may not be returned by the borrower, causing the lender to be compelled to incur a loss.
In order to minimize the risk element, lenders find ways to either gauge the creditworthiness of the borrower or secure the loan through other means, typically in the form of land or property collateral.
There are two broad categories of loans: secured and unsecured.
Unsecured loans have gained prominence in modern times due to fintechs finding new ways to evaluate an individual or a company’s creditworthiness by taking into account other factors, such as overall cash flow, salaried job status, business turnover, and an established credit score.
For secured loans, some form of security needs to be provided, in the form of a tangible asset, which can range from gold jewelry to real estate. The contractual agreement between lender and borrower establishes that if the borrower defaults on their loan payments for a certain period of time, the lender can seize the collateral and sell it to either partially or completely make up for their loss.
The nature of collateral and the terms related to it can vary widely depending on the type of loan and the lender’s policies. Let’s delve into the nuances of what this form of securitization entails.
Collateral is a tool to secure the loan on the part of the lender. Although lenders, especially traditional institutions like banks, also utilize various other factors like credit history and income stability to establish the creditworthiness of a borrower, collateral is still a preferred securitization option for most loans.
For loans issued without collateral, or unsecured loans, the risk undertaken by the lender is substantially higher, and therefore the interest rate applied in these loans is typically higher than that on secured loans. This category of credit includes loans like personal loans, student loans, and credit cards. The lender is also likely to thoroughly evaluate the financial status and repayment ability of the borrower before sanctioning an unsecured loan to them.
Another form of securitization involves having another individual besides the borrower become the guarantor for the loan. If the borrower defaults, the guarantor is required to repay the loan in their stead. Usually, the guarantor is required to have higher creditworthiness than the borrower, so that they can be relied upon to close the loan.
In contrast to these, a loan secured through collateral gives an increased degree of security to the lender. As a result, they are significantly easier to obtain but limited to those who already have such assets in their name. Such loans typically let borrowers access higher loan amounts and lower interest rates. This adds up to more favorable loan terms for the borrower.
The process of submitting an immovable asset as collateral is known as mortgaging, while putting up a movable asset as security against a loan is known as hypothecation. Assets can also be pledged to the lender, in which case the lender takes possession of them while the borrower retains ownership. Once the loan is closed, the movable assets are returned and claim of ownership on immovable assets is relinquished by the lender.
The borrower may fully claim both possession and effective ownership of the asset or property as long as the loan is repaid on time. There are various types of collateral and forms of security that can be utilized to secure a loan.
Here are the main types of collateral used for accessing a secured loan:
The most common form of collateral used by borrowers is real estate, such as one’s own home or a piece of land. This is the preferred form of collateral for lenders because real estate retains value and suffers a lower rate of depreciation. For the borrower, however, mortgaging property can be risky, especially if the property in question is their primary residence or their source of income.
Let us now explore some movable assets as collateral in more detail.
Many loans are provided against movable assets that hold resale value such as machinery owned by a business or vehicles. Hypothecating movable assets to the lender provides access to getting a loan, while retaining possession and even using the movable assets. . In some cases, it may involve transferring physical possession of the assets to the lender as well.
Gold is a common form of collateral, especially in countries such as India where many families have a tradition of buying gold or there might be generational gold passed down in the family. Gold bars, coins, and jewelry can be submitted to a lender in order to secure a loan, commonly known as a gold loan. Other valuables, such as fine art and antiques, can be pledged as collateral too, but since it’s difficult to gauge the true value of these assets and they may fluctuate, the ratio of the loan amount to the actual value of an asset is usually lower.
Cash collateral refers to the money in the savings account of the borrower. Often, a borrower can simply approach the bank where they maintain an active account and leverage the amount in their savings account to take a loan. In case of default, the bank can immediately access and liquidate the account, making it one of the most straightforward forms of collateral. This also means that the borrower can expect lower interest rates and fees on a loan secured with cash.
Business owners have two additional forms of collateral at their disposal which can be used to obtain a business loan. These are inventory financing and invoice collateral. Inventory financing refers to putting up the business’ inventory or stock not meant for immediate sale as collateral. In case of a default, the lender can seize and liquidate the inventory to recoup the losses.
Invoice financing, on the other hand, refers to submitting outstanding invoices or orders as collateral in exchange for a loan. This is done with the expectation that the payments will be made in due time, and will serve as loan repayment. This helps businesses regulate cash flows and keep their operations stable.
Personal investments in financial instruments such as stocks, bonds, and mutual funds, also known as securities, are another form of asset that can be leveraged as collateral for securing a loan, depending on the policy of the lender. This form of collateral is more commonly used for securing business loans and Line of Credit. Even while the loan is being repaid, the securities portfolio remains under the control of the borrower, and they can continue to benefit from the yields.
While this form of collateral, like cash, has the advantage of being easily liquidated by the lender in case of a default, it does come with an added degree of risk. This is because the value of such holding can fluctuate based on market movements, and is therefore less reliable than that of cash or property collateral. If the value of the investment declines past the borrowed amount, the borrower could be required to pay the balance to the lender even after the assets are repossessed.
While lenders usually work with borrowers to reduce the chances of a secured loan going into default, if it does happen, the lender might undertake the process of repossessing and liquidating the assets submitted as collateral in order to partially or completely recoup their losses. In the case of a mortgage, the process of the lender taking possession of the property is referred to as foreclosure.
As much as this process can be an ordeal for the borrower, lenders can be less than keen to initiate it as well, since it is a time-consuming and expensive process.
Collateral is a time-tested and widely used form of security for acquiring loans and it offers the advantage of lower risk for lenders and better loan terms for borrowers. However, lack of collateral excludes many from accessing credit that can help them improve their lives by growing their business, seeking educational opportunities, or being able to buy a home.
This is particularly true for last-mile borrowers who either don’t own assets that can serve as collateral or lack the formalization and understanding of the complicated paperwork required of them.
Hardika Shah is the founder and chief executive officer of Kinara Capital. Prior to Kinara Capital, she has worked as a management consultant with Accenture for over 20 years. Hardika holds a BA degree in computer science from Knox College in Illinois, USA, and pursued a joint MBA program by Columbia Business School and UC Berkeley’s Haas School of Business.
Armaan is the India Lead Editor for Forbes Advisor. He has more than a decade’s experience working with media and publishing companies to help them build expert-led content and establish editorial teams. At Forbes Advisor, he is determined to help readers declutter complex financial jargons and do his bit for India’s financial literacy.