Collateralization: Definition, How It Works, Examples By JULIA KAGAN Updated August 25, 2023 Reviewed by CHARLES POTTERS What Is Collateralization? Collateralization is the use of a valuable asset as collateral to secure a loan. If the borrower defaults on the loan, the lender may seize and sell the asset to offset their loss.
For lenders, the collateralization of assets provides a level of reassurance against default risk. For borrowers with poor credit histories, it can help them obtain loans. Collateralized loans are considered secured loans, so they generally have substantially lower interest rates than unsecured loans.
KEY TAKEAWAYS Collateralization provides a lender with security against default on a loan. Because it greatly reduces the lender's risk, the interest rates on collateralized loans are substantially lower. Businesses typically use collateralized loans to fund expansion and improvement projects. Understanding Collateralization A home mortgage and a car loan are two common examples of collateralization. The house or the car may be seized by the lender if the borrower defaults on the payments.
Collateralization is also common for business loans. A business owner may put up equipment, property, stock, or bonds as a security for a loan to expand or improve the business.
On a collateralized loan, the principal—the original sum of money borrowed—is typically based on the appraised collateral value of the property. Most secured lenders will lend about 70% to 90% of the value of the collateral.
For a lender, collateralized loans are inherently safer than non-collateralized loans, so they generally have lower interest rates. Non-collateralized, or unsecured, loans include credit cards and personal loans, which generally have much higher rates.
Interest Rates for Collateralized vs. Unsecured Loans For example, as of August 2023, here are sample interest rates for collateralized vs. unsecured loans:
Collateralized: An 36-month auto loan for a new car could be obtained at an average interest rate of 7.91% by an applicant with a good credit rating. 1 Collateralized: A 30-year fixed-rate mortgage could be obtained for an average interest rate of 7.23%. 2 Unsecured: On the other hand, the median rate of interest across all credit cards in the Investopedia card database was 23.99%. Unsecured or secured: Interest rates for personal loans, which can be either collateralized or unsecured, ranged from 4.6% all the way up to 36%.
Collateralized Business Loans When companies need loans to finance projects and operations, they can use equipment and property as collateral to secure bonds that are issued to investors as fixed-income securities. Fixed income provides investors with fixed interest payments as well as the return of principal at maturity, so bonds are a type of collateralized loan (corporate debt) between the company (the borrower) and the investor (the lender).
With bond offerings, the equipment and property is pledged as collateral for the repayment of the bond. In the event of the company's default, the underwriters of the deal can seize the collateral, sell it, and use the proceeds to repay investors.
The increased level of security offered to a bondholder (the lender) typically helps to lower the interest rate offered on the bond, which also decreases the cost of financing for the issuer (the borrower).