Collateral

Collateral reduces the lender's risk. If the borrower defaults, the lender can recover some or all of the money by selling the pledged asset. In return, the borrower usually gets a lower interest rate or a larger loan than would otherwise be possible.

Many kinds of assets can serve as collateral. A house secures a mortgage. A car secures a car loan. Businesses may pledge equipment, inventory, property or amounts owed by customers. Some loans are secured by savings or investments.

Lenders usually lend less than the full value of the collateral to protect themselves if its value falls. For example, a bank might lend up to 80% of a property's value, so a home worth 250,000 could support a mortgage of up to 200,000. This gap gives the lender a cushion if prices drop.

For borrowers, the key point is that collateral is at risk. Missing payments on a secured loan can mean losing the asset, so it should only be pledged for borrowing that is clearly affordable.