What is collateral?
Welcome to professrsavings.com, we teach finance basics. Today we will teach you what is a collateral.
Hi I’m Rayfil Wong. We hope these investment concepts will help you be a better investor.
Collateral is property or other assets that a borrower offers a lender to secure a loan.
Let’s say if the borrower stops making the promised loan payments, the lender can seize the collateral to gain back its losses.
Professor Savings wants to buy a house.
The house costs $500,000, but he only has $100,000. To buy the house, he needs a loan from the bank for $400,000.
For the bank to loan Professor Savings such a large sum, it needs a way to protect itself in case he is unable to repay the loan also known as defaulting on a loan.
The bank requires Professor Savings to pledge the house as collateral for the loan.
As long as Professor Savings continues to make the monthly payments, he gets to keep the house and the entire family will be in good hands.
And since the bank can recoup some of its losses by selling the house that he defaults, it’s willing to give him a low interest rate of just 6%.
The moment that Professor Savings pays off all the loans, the home will no longer be collateral and the bank won’t have any rights to the house.
Here’s another example.
Professor Savings wants to open a cupcake bakery, but he doesn’t have any kitchen equipment.
He needs to buy a big commercial oven. Professor Savings just graduated from chef school and doesn’t have much cash, so he takes out a small business loan to pay for these purchases.
Unicorn Bank requires Professor Savings to put his commercial oven as loan collateral. In the worst case scenarios, Professor Savings fails and he can’t repay the loan.
Then Unicorn Bank can sell his equipment and get some of its money back.
Since his new business is fairly risky, the bank still wants 15% interest, but it is less than the 18% Professor Savings would pay if he bought the equipment with a credit card.