This lesson will define collateral from the viewpoint of both an individual and a business owner. Also in this lesson, various types of collateral will be explained, and examples of collateral will be explored.
Definition of Collateral
Have you ever borrowed money from a friend and made assurances to pay them back? Maybe you even gave more than just verbal assurances and also pledged that you would give up something of yours if you didn’t pay them back in time? For instance, you might have said, ‘I promise to pay you back, and if I don’t, you can have my stereo.’ What you pledged your friend — your stereo — is collateral.
Collateral is when an asset is pledged to secure repayment. It is common in personal and business lending. You may hear friends or family refer to collateral as a home, a car, or a commercial building or property. These examples are not all-inclusive; rather, they are provided to illustrate various types of collateral you may encounter in your lifetime.
Types of Collateral
There are five main types of collateral: consumer goods, equipment, farm products, inventory, and property on paper.
Consumer goods are products purchased by the mainstream consumer, such as an automobile.
Equipment includes items predominantly used in business or government operations.
Farm products include livestock and crops.
Inventory consists of raw materials or work in progress.
Property on paper includes stocks, bonds, and even funds held in a savings or checking account.
It is important to note that this list is not all-inclusive; almost anything of value (within reason, of course) can be offered as collateral.
Examples of Collateral
Let’s explore different collateral an individual could use throughout different stages of his or her lifetime.
Let’s call Stage 1: The College Graduate
John Doe, a recent college graduate, is in the market for a car. When John graduated from college, his dad gave him a family heirloom, a watch valued at $3,000. John is in the market for a $5,000 car but has limited credit history and little cash on hand.
John recently started a new job and expects to be able to afford monthly car payments of a few hundred dollars. He’s looking through the paper and sees that one of his neighbors is selling their used car for $5,000. John can use his watch as collateral to the seller, if the seller desires it. This could give John a better interest rate, as the potential worst-case scenario to the seller is that he ends up with a watch valued at $3,000.
After a few years, John has married, upgraded his vehicle, and is burnt out at his job. Now he’s on to Stage 2: The Entrepreneur.
John’s made the decision to make his own way by starting a technology company. John, however, needs to hire employees, and those employees need a place to work. John looks at buying a building in town and also inquires on a line of credit, but the bank requires collateral since John doesn’t have any money saved for a down payment and this is a new business.
In order to get what John believes to be a good interest rate, he offers the building he is purchasing, along with his watch (the family heirloom), and his family’s vehicles as collateral. The bank is satisfied and John opens his technology company.
Ten years later, business is booming but John has hit the next stage- he’s a family man. John’s little girl is ready to go to private school. John goes to the bank again, this time looking for a loan to help pay for private school. The bank offers him a home equity line of credit, using their home as collateral. Should John not follow the repayment schedule (even if he is only required to pay back the interest), the bank may choose to foreclose on the property.
Collateral is a concept that is prominent in both individual and business lending. Collateral is when an asset is pledged to secure repayment. The five main types of collateral are consumer goods, equipment, farm products, inventory, and property on paper. All can be used as collateral when applying for loans, provided there is a recognizable value associated with the item.
The type and amount of collateral required from you by a lender may vary with time. Further, as disclosed in the examples, the risk of using collateral is if you fail to make good on your promise to repay the lender, the lender may have no choice but to transfer ownership of the item from you to them.