A collateral is a guarantee made by the borrower that institutes and obligation of pledging a certain property to the lender. This property is to serve as security until the loan is repayed in full. In case the borrower defaults (is not able to return the loan) the property, which serves as collateral, it can be seized and sold by the lender in order to sell it and return the money he invested in the loan. The borrower forfeits the pledged property and the lender becomes the owner so the property is at his disposal. When it comes to mortgages, the typical scenario is that the loan is secured by the property being bought by the borrower.
The real estate bought (an apartment, a house, a building etc.) serves as collateral, in case the borrower defaults. If this happens, the ownership of the real estate is transferred to the bank. Bank has legal instruments which allow it to obtain the real estate serving as collateral.
Collaterals are not limited to real estate, although when it comes to mortgage. Real property serves as the usual way of securing the loan (typically called asset-based loans). When it comes to trading, however, there are a number of complex collateralization arrangements in use (capital market collateralization). Unilateral obligations such as surety, property, guarantee or other collateral are commonly used in the financial markets.
Types of collateral
If the collateral is such that it can be exchanged for money fairly quickly, under normal market conditions and at current fair market value, we speak of marketable collateral. These types of collateral mean an exchange of financial assets, which most oftenly include stocks and bonds. Loans that are secured with marketable collateral always involve financial institutions and a borrower.
The conditions under which these collaterals are exchanged for money are based upon current market conditions and various methods and institutions exist which form the prices of many financial instruments like stocks and bonds. The main risk involved with marketable collaterals is the reduction of collateral values. The market value of a collateral can fall very quickly (but it can rise as well) which could jeopardize the lenders capital.
There are designated financial institutions organized so they can closely watch on the market value of many financial assets. This way they can take appropriate measures if the value of collateral goes down enough, below the loan-to-value ratio determined in the loan conditions. Loan contracts will usually define such situations.
Sometimes cross-collateralization can occur. This happens when collateral for one loan is used as collateral for another loan. For instance, a person buys a home and secures the loan with the same house, buys a car and secures this loan with the same car and so one. In this situation, if the same bank provided the loan. These asset can be used to secure all the loans taken by the same person.
In the case mentioned, for example, if the person who has still to pay off the loan for the house and wants to sell the car, may not be able to do so because the bank will have the right to veto the sale because the car is used as cross-collateral for the house loan.