What is Collateralization?
Collateralization occurs when a company pledges an asset to a lender (usually in return for a loan). The lender has the right to seize the collateral if the borrower defaults on the obligation.
How Does Collateralization Work?
Let’s assume you would like to borrow $100,000 to start a business. Even if you have an excellent credit rating, a bank may be reluctant to lend you the money because it may be left with nothing if you default on the loan. Thus, although banks may attempt the lengthy and expensive process of suing you in that circumstance, the bank may require $100,000 of collateral in order to lend you the money. This collateral might consist of financial instruments, houses, cash, or even objects such as art, jewelry, or other items. You might also pledge your business receivables as well. When you pledge these assets, you are collateralizing the loan.
If you default on the loan, the loan agreement gives the lender the right to seize and sell the collateral in order to recover any outstanding balance.
Why Does Collateralization Matter?
Collateralization provides a sense of security to a lender, which is why collateralized loans often receive better interest rates than unsecured loans because the lender bears less risk. However, the type and amount of collateralization required for a given loan is often a matter of negotiation between the lender and borrower. For instance, a lender might require a borrower to collateralize any assets purchased during the loan period. In some cases, collateral for one obligation can also be collateral for other obligations (this is called cross-collateralization). This often occurs in real estate transactions, where a house collateralizes more than one mortgage.