If you have ever approached a lending institution for a loan to meet your financial goals, chances are that you may have heard the term ‘collateral.’ Have you ever wondered what it means? And is it applicable to all kinds of loans? That’s just what we’re going to be looking at today.

What is collateral?

When you borrow money from a lender, the lender takes on a certain amount of risk by giving you the funds you need. There is always the possibility that you may fail to repay the loan, resulting in a huge loss for the lender. So, in some cases, lenders require you to pledge an asset as collateral. This reduces the risk of default for the lender, because in case you do not repay your loan, the asset can be sold and the proceeds can help cover the lender’s losses.

How does a collateral work?

When you offer an asset as a collateral, the lender places a lien on the asset. In case you default on your loan and fail to pay back the amount borrowed, the lender then secures the asset you put up as collateral and sells the same in the market. The proceeds from the sale are used to make up for the loss arising from the loan default. 

What assets can be used as collateral?

Some lenders and some kinds of collateral loans may have specific requirements about the kind of assets that you can pledge when you borrow funds. Broadly speaking, however, the following assets can be offered as collateral.

• Any commercial or residential property in your name
• Any private vehicle that you own
• Machinery and equipment that you or your business owns
• Investments held by you, such as gold, shares, bonds, mutual funds or fixed deposits
• Your insurance policy 
• Any receivables that you are due to receive

Do all loans need collateral?

Not all loans require collateral. Based on whether or not you need to offer an asset as security, loans can be categorized as follows.

• Secured loan:

A secured loan is one where you need to offer up an asset as collateral. This is why it is also colloquially known as a collateral loan.

• Unsecured loan:

An unsecured loan is one where you need not offer up an asset as collateral. This kind of a loan is colloquially known as a collateral-free loan.

Collateral-free loan meaning

A collateral-free loan is easier to obtain, since you do not have to pledge any asset as security. For example, take the case of a personal loan. This kind of loan allows you to borrow funds to meet a variety of personal needs like paying for a vacation or a wedding, repaying other debts in your name, or simply indulging in a premium purchase. 

Since the risk for the lender goes up due to the lack of collateral, personal loans have higher rates of interest than other kinds of loans that are secured.

Collateral loan meaning

A collateral loan is just a secured loan where the lender requires additional security in the form of an asset. There are different types of collateral loans available in the market, and they each serve certain specific needs of the borrower. Since the asset pledged minimizes some of the risk associated with the loan, collateral loans typically have lower rates of interest than collateral-free loans. 

Types of loans that need collateral

Here’s a closer look at some of the many collateral loans or secured loans available in the Indian market. You may already be familiar with some of them.

• Home loan

A home loan is availed by pledging the very property for which you are availing the loan. So, if you are borrowing funds to buy, build, or renovate your house, the house property is offered as collateral.

• Vehicle loan

Much like in the case of a home loan, the asset for which you are availing the loan is itself the collateral in a vehicle loan too. So, if you take a car loan, the car that you intend to purchase is taken as the security, whereas in the case of a two-wheeler loan, the vehicle is the collateral. 

• Loan against property

You can also offer up an existing property in your name as collateral in exchange for a loan. This is quite different from a home loan, because in the case of a loan against property, you can use the proceeds for any purpose with no restrictions. 

• Loan against security 

If you hold any securities like shares or bonds, you can offer them as collateral for a loan. The amount of loan you can obtain will depend on the value of the securities you pledge.

• Gold loan

Gold loans, as you may have guessed, consider gold as the collateral in exchange for funds. You can pledge any gold ornaments, coins or bars you own and obtain funds to meet your emergency needs.

Wrapping up

This should answer your question about whether or not all loans need collateral. Keep in mind that the amount of loan you qualify for generally depends on the value of the collateral you offer. Also, before you avail a collateral loan, ensure that you read the terms and conditions involved thoroughly. And if you have any more questions about loans, you may find the answers to them in the following chapter. 

A quick recap

• Lenders may require you to pledge an asset as collateral. This reduces the risk of default for the lender, because in case you do not repay your loan, the asset can be sold and the proceeds can help cover the lender’s losses.
• Not all loans require collateral. Based on whether or not you need to offer an asset as security, loans can be categorized as secured or unsecured loans.
• Secured loans are collateral loans, while unsecured loans are collateral-free loans.
• Home loans, vehicle loans, loans against property, gold loans and loans against security are some examples of collateral loans.
• Personal loans are the most common types of collateral-free loans.