Collateral – Definition, Types, Example and More

The concept of a collateral may sound complicated, but in reality it is quite simple. In this article, we will talk about collateral and explain scenarios wherein it comes to play.

First, let’s understand the primary question.

What Is a Collateral?

Collateral is any movable or immovable asset that you can pledge to the lender to get a loan. In case of a default, the lender can take possession of the collateral and recover the loan amount.

The collateral works as a security for the lender. This is the reason loans with collateral are called secured loans. Loans without any collateral are called unsecured loans. 

When approving a loan, the lender wants as little risk as possible. They want to ensure that they recover their money and that is where collateral comes into the picture. 

Let us take a basic example.

Let’s say Ram wants to borrow some money and approaches an NBFC for the same (NBFC give out loans to individuals). The NBFC agrees to give him a loan, but says that he needs to provide a collateral as a security against the loan.  And why do they ask for a collateral? In case, Ram is unable to pay off the money, the gold can be sold to recover the amount. This is probably the most basic example and there are a lot of processes that follow.

A collateral-based loan can be beneficial for both the lender and the borrower. It offers more security to the lender and may result in a lower rate of interest for the borrower. 

Types of Collaterals

Several types of collateral can be used when looking for loans. Some popular types are. 

1. Property

Using one’s home or any owned piece of property is the most common type of collateral.

These properties generally have high value and less depreciation. However, pledging such assets can be relatively risky as the lender can take its possession in case of default in payment.

2. Bank Deposits

An individual can take a loan on the active accounts that he maintains in the bank like a savings account, fixed deposits etc.

3. Inventory Financing

The items listed in the inventory serve as collateral for a loan. There are two basic types of inventory financing, the first is an inventory loan, the second is an inventory line of credit. 

4. Invoice Financing

These are generally used by small businesses, the outstanding and unpaid invoices given to customers of the business are used as collateral for financing.

Advantages of Taking a Collateral Based Loan

These are some of the major advantages of taking a collateral based loan.

Cons of Taking a Collateral Based Loan

There are a few disadvantages of collateral based loan. They are as follows.

The Current Scenario

As per an Indian Ratings report, due to deteriorating financial conditions and an uncertain economy, because of the ongoing global pandemic, the performance of unsecured loans have declined. 

However, secured loans present a stable outlook considering the economy recovering in FY22. Of all the asset classes, loan against property had the most promising outlook. A land which is immobile and easy to transfer should be the ideal collateral.

However, it also came to light that most Indians do not prefer to use land as collateral. As per a National Sample Survey Organisation study, which was based on data collected in 2012-13, only 2.9 % of total loans in rural areas and 4.5% in urban India had land as collateral.

As per a research, Indians (61.8% in rural areas and 58.1% in urban areas) depend primarily on unsecured loans. The surprising fact is that most of it is sourced from non-institutional sources like money lenders.

Even when collateral is used, it is more in moveable assets such as gold, jewellery, and promissory notes. Based on these observations, the report highlighted several barriers of using land as collateral.

Land in Indian households have a significant emotional, and cultural value and it is considered as a last resort.

Other reasons include inadequate land records, multiple landowners, and cumbersome documentation work when land is used as collateral.

The decision on whether to go for a collateral-based loan eventually is a personal choice. It ultimately depends on several factors like how much you want to borrow, your credit score, and the type of collateral you want to offer.

Whatever kind of loan or the amount you require, make sure to have a repayment plan in place to avoid heavy consequences of a default. 

On the other side of the spectrum you can also become a lender. If you invest in assets offered by companies like Wint Wealth, you can invest in bonds (bankruptcy protected bonds) offered by NBFCs and earn returns upto 9-11% p.a. And here, the NBFC becomes the borrower and is oblidged to pay you an interest

Happy Winting!