Collateral is an asset or property that a borrower pledges to a lender as a security or guarantee for a loan. This arrangement helps mitigate the lender’s risk, as it provides them with a form of compensation if the borrower fails to repay the loan as agreed—an event known as default.

Collateral can be tangible, such as real estate, vehicles, machinery, or inventory, or it can be financial assets like cash, stocks, bonds, or savings accounts. The specific type of collateral required often depends on the size and type of the loan. For instance, a mortgage is typically secured by the property being purchased, while a car loan is secured by the vehicle itself.

If the borrower defaults on the loan, the lender has the legal right to seize the collateral and sell it to recover the outstanding debt. This process is commonly seen in foreclosure proceedings, where a bank may take possession of a home and sell it if the homeowner fails to make mortgage payments.

Collateralized loans often come with lower interest rates compared to unsecured loans (which don’t require collateral), as the presence of collateral reduces the lender’s risk. However, for the borrower, there is the risk of losing the pledged asset if they are unable to fulfill the loan repayment terms. This makes collateral an essential consideration in both lending and borrowing decisions, impacting the terms of the loan and the potential consequences of non-payment.