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Inlending agreements,collateral is aborrower'spledge of specificproperty to alender, tosecure repayment of a loan.[1][2] The collateral serves as a lender's protection against a borrower'sdefault and so can be used to offset the loan if the borrower fails to pay theprincipal andinterest satisfactorily under the terms of the lending agreement.
The protection that collateral provides generally allows lenders to offer a lowerinterest rate on loans that have collateral. The reduction in interest rate can be up to several percentage points, depending on the type and value of the collateral. For example, theAnnual Percentage Rate (APR) on anunsecured loan is often much higher than on asecured loan orlogbook loan.
If a borrower defaults on a loan (due toinsolvency or another event), that borrower loses the property pledged as collateral, with the lender then becoming the owner of the property. In a typicalmortgage loan transaction, for instance, thereal estate being acquired with the help of the loan serves as collateral. If the buyer fails to repay the loan according to the mortgage agreement, the lender can use thelegal process offoreclosure to obtain ownership of the real estate. If asecond mortgage is involved the primary mortgage loan is repaid first with the remaining funds used to satisfy the second mortgage.[3][4] Apawnbroker is a common example of a business that may accept a wide range of items as collateral.
The type of the collateral may be restricted based on the type of the loan (as is the case with auto loans and mortgages); it also can be flexible, such as in the case of collateral-based personal loans.
Collateral, especially withinbanking, traditionally refers tosecured lending (also known asasset-based lending). More-complex collateralization arrangements may be used to securetrade transactions (also known ascapital market collateralization). The former often presents unilateral obligations secured in the form ofproperty,surety,guarantee or other collateral (originally denoted by the termsecurity), whereas the latter often presents bilateral obligations secured by more-liquid assets (such ascash). Collateralization of assets gives lenders a sufficient level of reassurance against default risk. It also help some borrowers to obtain loan if they have poor credit histories. Collateralized loans generally have substantially lower interest rate than unsecured loans.
Marketable collateral is the exchange offinancial assets, such as stocks and bonds, for a loan between a financial institution and borrower. To be deemed marketable, assets must be capable of being sold under normal market conditions with reasonable promptness at currentfair market value. For sizeable banks to accept a borrower's loan proposal, collateral must be equal to or greater than 100% of the loan or credit extension amount. In the United States of America, the bank's total outstanding loans and credit extensions to one borrower may not exceed 15 percent of the bank's capital and surplus (plus an additional 10 percent of the bank's capital and surplus if the bank fulfills certain qualifications).[5]
Reduction of collateral value is the primary risk when securing loans with marketable collateral. Financial institutions closely monitor themarket value of any financial assets held as collateral and take appropriate action if the value subsequently declines below the predetermined maximum loan-to-value ratio. The permitted actions are generally specified in a loan agreement or margin agreement.
Intellectual property such ascopyrights,patents, andtrademarks, as well as royalty streams from licensing revenue, are increasingly being used as collateral.[6] The use of IP as collateral in IP-backed finance transactions is the subject of a report series at theWorld Intellectual Property Organization.[7]
Many agricultural assets can be used as collateral,[8] even unharvested crops in some cases.[9] Some Italian banks (such as theCredito Emiliano) accept wheels of agingParmigiano Reggiano cheese as collateral, and may even provide high-quality storage for it.[10][11]
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