Collateral

What Is Collateral?

Collateral is an asset pledged as security for a loan, which the lender can claim if the borrower fails to repay.

Simply put, collateral is something of value given as a guarantee to obtain something else. For instance, a borrower may offer a car as collateral to a lender when taking out a loan. The vehicle acts as a safeguard in case the borrower fails to pay their debts.

Usually, collateralized loans carry lower interest rates when compared to non-collateralized ones, because the lender has a way to recover value if the borrower defaults.

What Are the Common Types of Collateral?

Collateral can come in different forms. Some of the most common types include mortgage collaterals, invoice financing, and margin trading collaterals.

• Mortgage or real estate collateral

These are among the most used by borrowers. They refer to loans backed by real estate properties, such as an apartment, house, or farming land. The property is the asset that secures the loan, so if the borrower fails to make payments as per the contract, the lender has the right to claim ownership of the property.

• Invoice financing

This is a short-term borrowing procedure employed by businesses. It consists of companies using customers' invoices that are yet to be paid as collateral, which allows them to access funds in advance. 

For example, imagine that an online retailer sold $500,000 in products, but since most consumers paid by credit card, the company cannot use the money anytime soon. Invoice financing would be suitable in this case, allowing the company to improve cash flow and use the money beforehand for high-priority needs.

• Margin trading collateral

When it comes to margin trading, the term refers to the assets kept in a margin trading account to cover potential losses traders may have when trading on leverage. In other words, when you borrow money to trade on margin, your account balance acts as collateral. The brokerage or exchange reserves the right to liquidate your assets in case the market moves against you.

How Is Collateral Used in Crypto?

In crypto markets, collateral is the foundation of two major activities:

• Crypto-backed loans

• Margin and leveraged trading