Collateral is one of the most important terms in today’s financial world.
Collateral represents any asset that is offered as security when someone takes out a loan. The idea behind collateral is to ensure that the borrower is going to either pay back the loan to get back the collateral or the lender will have the equivalent of the sum borrowed. The way collateral works depends on the agreement signed by the lender and the borrower.
One of the most used forms of collateral is property. When you take out a mortgage, for example, the property you’re buying is the collateral. The bank gives you a loan under the condition that if you fail to pay your debt, the bank is going to take ownership of the property you bought. This form of collateral is often referred to as a collateralized mortgage obligation (CMO).
While mortgages are the most popular form of collateral agreements, any other asset can be considered collateral if the lender agrees. For example, you can borrow money against your car, a given amount of gold or silver, or even your watch. Depending on the institution or person who assumes the role of a lender, and the type of loan you need, collateral can be almost anything that has monetary value.
The main idea behind collateral is to minimize risk for the lender as much as possible. Taking collateral is the lender’s guarantee that even if the borrower defaults on their loan, the lender will not be left empty-handed. Traditionally, banks can offer customer credit lines without collateral when smaller amounts are requested. However, when a loan request surpasses a certain amount, the bank usually requests some form of collateral.
One important thing to note here is that usually, loans backed by collateral offer significantly better interest rates. As the borrower offers additional assurance to the lender that the loan will be repaid, interest rates for collateralized loans are traditionally lower. This is one of the reasons why collateral-based loans have become so popular over time. While the borrower is required to forfeit the collateral if they default on the loan, the total amount they have to repay is smaller. Considering this, many borrowers prefer to offer collateral in order to reduce the additional cost high interest rates lead to.
In cryptocurrency, collateralization is also steadily gaining traction with the introduction of collateral tokens. The idea behind collateral tokens is largely the same as in the traditional financial markets, as they serve as a risk mitigator for crypto-based lenders. As cryptocurrency loans become more popular, and people turn to the blockchain to manage their finance, collateral tokens are also becoming increasingly sought after.
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