What is collateral and should I include it in my loan agreement?

If a loan agreement includes collateral, it means that the borrower has agreed to pledge certain assets as security for the loan. In the event the borrower defaults and does not uphold his or her agreement to repay the loan amount plus interest, the lender gets to keep the pledged collateral. Loans that use collateral are often referred to as “secured loans.”

In theory, almost any asset can be used as collateral. However, in practice, most lenders will only want collateral that they could actually use or sell in the event the borrower defaulted on the loan.

When you buy a home, your house is the collateral for a home mortgage. Similarly, auto loans are secured by the vehicle itself. Personal loans may be secured by stocks or bonds, bank accounts, insurance policies, machines or equipment, collectibles, future payments from the borrower’s customers (accounts receivable), or by other financial asset(s).

Generally speaking, pledging collateral for a loan can be advantageous to the borrower because the lender may be willing to offer a lower interest rate or loan a larger dollar amount. The lender’s risk of loss is lower because it knows it can keep the borrower’s collateral in the event of a default.

Borrowers should make sure they will be able to adhere to the terms of the loan agreement so they do not risk losing their pledged assets.

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