Definition
The term collateral refers to an item of value, or an asset, provided by someone as a guarantee to obtain something else.
Understanding the term
Collateral refers to an asset accepted by a lender as security for a loan. It may take the form of real estate, immovable assets, or any other form of asset, depending on the loan’s purpose.
For example, a borrower may offer their car as collateral to a lender for securing a loan. In this case, the vehicle is the safeguard or warranty in case the borrower fails to pay their debts within the stipulated time.
Loans that are collateralized have much lower interest rates associated with them compared to traditional loans. Some of the most common types of collateral include mortgage, invoice financing, and margin trading collaterals. Collateral is also used in the cryptocurrency market.
Similar to a securities-based loan, cryptocurrency-backed loans use digital currencies as collateral. The basic principle remains the same – the borrower pledges their crypto assets to obtain the loan and pay it off within the stipulated period.
Takeaway
Collateral simply refers to an item of value used to secure a loan. It minimizes the risk taken by lenders. The lender can seize the collateral and sell it to recoup losses if the borrower defaults on the loan.