Collateralization Meaning Types How Does It Work

Collateralization Meaning

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. An asset is pledged with the lender, who charges the same in this process. It acts like a recourse in the event of default by the borrower.

Various assets could be used as collateral, such as jewelry, immovable property, vehicles, inventories, etc.

How Do 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 percentage of asset value. We can better explain that 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.read more of 80%. Ms. Susan owns property on Fame Street, New York, with a market value of $800,000, and approached BoA to obtain a loan for her new business venture. She 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 full loan of $720,000.

Types of Loan Collateralization

As collateralization is a mechanism to secure the loan offered by the lender, one can use it for various loan facilities that the bank or financial institutions provide. Some types of loans for which collateralization can be used are as under: –

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#1 – Mortgage Loans

A mortgage loan refers to the loan availed against the property’s title. 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 until the loan has been repaid by the borrower, post which the title gets transferred to the borrower. If the borrower defaults in repayment of the principal amount of interest, 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.read more, term loans, issuance of bonds, etc. collaterals are often used in most business loans. Business loans can have all kinds of assets as collateral. For example, a loan availed for equipment purchase by a hospital can have the equipment purchased as mortgaged with the bank. It is pledged to provide security to the lender to repay his amount. 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.read more 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 the company.

#3 – Investor Loans

Often, brokerage firms allow investors to obtain loans against their securities. Investors who do not have sufficient funds in the account and wish to trade on the margin allowed by the brokerage firms can avail of the margin based on the securities held in their account.

The margin allowed is usually multiple times the value of securities held in the account. Such a margin is permitted only for a short duration, after which it needs to be settled either through the sale of securities purchased or through adding more funds to the accounts.

Conclusion

Collateralization is a mechanism of securing loans by offering assets to the borrower as collateral. Such collaterals usually provide a way faster and ensure access to loans. Banks and financial institutions look at the maximum loan-to-value ratio before releasing the loans to individuals or businesses.