Collateral is an asset or property that a borrower offers to a lender (a bank) as security for a loan. It acts as a backup for the bank. If the borrower fails to repay the loan, the bank has the right to seize and sell the collateral to recover its money.
Characteristics of Good Collateral
Not every asset makes for good collateral. A bank looks for these key features:
- Easy to Value: The asset’s market price should be easy to determine.
- Easy to Take Possession of: The bank should be able to take control of the asset without legal hurdles.
- Easy to Sell: The asset should have a ready market so it can be sold quickly.
- Stable Value: The asset’s price should not fluctuate wildly.
- Clear Title: The borrower must have clear and undisputed ownership of the asset.
Types of Collaterals
Collateral can be broadly categorised into different types.
1. Immovable Property
Property that cannot be moved from one place to another. This is the most common form of collateral for high-value loans.
- Examples:
- Land and Building: A house, apartment, or commercial shop.
- Vacant Land: A plot of non-agricultural land.
- Charge Created: Mortgage.
2. Movable Property
Assets that can be moved from one place to another.
- Examples:
- Vehicles: Cars, trucks, tractors.
- Goods/Inventory: Raw materials or finished goods in a company’s warehouse.
- Machinery: Industrial equipment in a factory.
- Charge Created: Hypothecation or Pledge.
3. Financial Securities
Paper or electronic assets that have a financial value.
- Examples:
- Fixed Deposits (FDs): A Fixed Deposit Receipt from a bank. This is considered one of the best collaterals as its value is certain.
- Shares and Mutual Funds: Units of listed companies or mutual funds.
- Life Insurance Policies: The surrender value of the policy is considered.
- Government Securities: Bonds like National Savings Certificates (NSC).
- Charge Created: Pledge or Lien.
4. Personal Guarantee
This is not a physical asset. It’s a promise given by a third person (the guarantor) to repay the loan if the primary borrower defaults.
- Key Feature: The strength of the guarantee depends on the financial net worth and creditworthiness of the guarantor.
- Example: A director of a company gives a personal guarantee for a loan taken by the company. If the company fails to pay, the bank can recover the money from the director’s personal assets.
Summary
Collateral is the lender’s safety net in a loan transaction. It reduces the risk for the bank and makes it more likely for a borrower to get a loan. The most common types of collateral include immovable property like a house (secured by a mortgage), movable property like a car or inventory (secured by hypothecation), financial securities like Fixed Deposits, and personal guarantees from a creditworthy individual. A good collateral is one that is valuable, stable, and can be easily sold if the need arises.
Quick Revision Points
- Collateral: An asset pledged as security for a loan.
- Main Purpose: To protect the lender (bank) from the risk of default.
- Immovable Property: Land & Building. The charge is a Mortgage.
- Movable Property: Car, Inventory, Machinery. The charge is Hypothecation or Pledge.
- Financial Securities: FDs, Shares, Insurance Policies. The charge is a Pledge or Lien.
- Best Collateral: Bank’s own Fixed Deposits are considered the best.
- Personal Guarantee: A promise from a third party to repay. Its value depends on the guarantor’s net worth.
- Good Collateral: Must be easy to value, possess, and sell.