In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.[1][2] The collateral serves as a lender's protection against a borrower's default—that is, it can be used to offset the loan if the borrower fails to pay the principal and interest satisfactorily under the terms of the lending agreement.
The protection that collateral provides generally allows lenders to offer a lower interest rate on loans that have collateral compared to those that do not, because the risk of loss to the lender is lower. The reduction in interest rate can be up to several percentage points, depending on the type and value of the collateral. For example, the interest rate (APR) on an unsecured loan is often much higher than on a secured loan or logbook loan, as in this case the risk is increased for the lender.[3]
If a borrower does default on a loan (due to insolvency or other event), that borrower forfeits (gives up) the property pledged as collateral, with the lender then becoming the owner of the property. In a typical mortgage loan transaction, for instance, the real estate being acquired with the help of the loan serves as collateral. Should the buyer fail to repay the loan according to the mortgage agreement, the lender can use the legal process of foreclosure to obtain ownership of the real estate. A pawnbroker is a common example of a business that may accept a wide range of items as collateral.
