Collateral

Collateral refers to assets given or pledged as security for payment of a loan. Houses, cars, and other types of property are examples of tangible assets used as collateral. A potential problem with collateral arises if one is unable to pay off a loan as scheduled: The collateral assets will be sold, and the money raised by selling the assets will be used to repay the loan. Typically, collateral consists of financial instruments—stocks, bonds, and negotiable paper. Physical goods, however, may be accepted as collateral also.

Collateral items are generally of significant value. But the range varies considerably, depending on the terms of the lending institution's contract with the borrower. A collateral contract is a contract where the consideration is the entry into another contract, and coexists side by side with a main contract. For example, a collateral contract is formed when one party pays another party a certain sum of money for entry into another contract. Still, a collateral contract may be entered into between one of the parties and a third party. In short, many different types of collateral arrangements can be made by companies, whether they are experiencing a financial crunch or making plans for expansion.

Usually, collateral only comes into play when a company needs to make a secured loan—a loan that uses tangible assets as collateral. Contrary to unsecured loans, where a borrower is able to get a loan solely on the strength of its credit reputation, secured loans require a borrowing company to put up a portion of its assets as additional assurance of repayment.

Many start-up businesses often use collateral-based loans. The advantage of such loans is that they have lower interest rates. Unsecured loans, by contrast, have higher interest rates. A problem with many small businesses is that most do not have enough collateral to get a secured loan from a lending institution. Consequently, such businesses often rely on equity financing instead. Notwithstanding the foregoing, borrowers have a broad array of options when using collateral.

A borrower may substitute other collateral for that held by a lender. Such a privilege is particularly useful for borrowers who buy and sell securities. For instance, merchandise collateral, such as negotiable warehouse receipts, bills of lading, and trust receipts are often used. Additionally, personal collateral—deeds, mortgages, leases—is frequently used. Finally, collateral may include bills of sale for crops, machinery, furniture, and even livestock.

When a borrower defaults on a loan, a creditor may sell collateral so it can be liquidated—turned into cash—and apply the money acquired to satisfy the debt. The creditor will charge the debtor with any deficiency remaining but will credit the debtor with any surplus. Accordingly, borrowers usually do not put their biggest asset on the line, unless payment can be made pursuant to the contract.

In today's increasingly complex world of multinational conglomerates, there are several forms of intellectual property that may be pledged as primary sources of collateral—trademarks, patents, derivative royalties. A cologne manufacturing company, for instance, may use its trademarks and future stream of royalties from its trademarks as collateral for millions of dollars in financing.

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