The lending process inherently involves taking on some degree of risk on the part of the lender. Indeed, it is possible that the loaned capital is not returned by the borrower, forcing the lender to suffer a loss.
In order to minimize the element of risk, lenders find ways to assess the creditworthiness of the borrower or secure the loan in other ways, usually in the form of land or real estate collateral.
Types of loans
There are two main categories of loans: secured and unsecured.
Unsecured loans have risen to prominence in modern times as fintechs have found new ways to assess the creditworthiness of an individual or business by considering other factors, such as the flow overall cash flow, salaried employment status, turnover and an established credit rating.
For secured loans, some form of Security must be provided, in the form of a tangible asset, which can range from gold jewelry to real estate. The contractual agreement between the lender and the borrower establishes that if the borrower does not repay his loan for a certain period, the lender can seize the collateral and sell it to partially or completely compensate for his loss.
The nature of the guarantee and the conditions attached to it can vary considerably depending on the type of loan and the policies of the lender. Let’s look at the nuances of what this form of securitization entails.
Why is a guarantee necessary?
Collateral is a tool to secure the loan from the lender. Although lenders, especially traditional institutions like banks, also use various other factors such as credit history and income stability to establish a borrower’s creditworthiness, collateral remains a preferred securitization option for most. loans.
For loans issued without collateral or unsecured loans, the risk taken by the lender is considerably higher and therefore the interest rate charged on these loans is usually higher than that of secured loans. This category of credit includes loans like personal loans, student loans, and credit cards. The lender is also likely to thoroughly assess the borrower’s financial condition and repayment capacity before granting an unsecured loan.
Another form of securitization involves having someone other than the borrower become the guarantor of the loan. If the borrower defaults, the guarantor is required to repay the loan on his behalf. Usually, the guarantor must have a higher creditworthiness than the borrower, so that he can be relied upon to conclude the loan.
Unlike these, a loan secured by collateral gives an increased degree of security to the lender. As a result, they are much easier to obtain but limited to those who already have such assets in their name. These loans generally allow borrowers to access higher loan amounts and lower interest rates. This is in addition to more favorable loan terms for the borrower.
Different types of warranty?
The process of pledging immovable property as collateral is known as a mortgage, while pledging movable property as security for a loan is known as a pledge. Assets can also be pledged to the lender, in which case the lender takes possession of them while the borrower retains ownership. Once the loan is closed, the movable assets are returned and title to the real estate is relinquished by the lender.
The borrower can fully claim both possession and beneficial ownership of the asset or property as long as the loan is repaid on time. There are different types of collateral and forms of collateral that can be used to secure a loan.
Here are the main types of collateral used to access a secured loan:
- Land or real estate security (real estate)
The most common form of collateral borrowers use is real estate, such as their own house or land. This is the preferred form of security for lenders because real estate retains its value and suffers a lower rate of depreciation. For the borrower, however, mortgaging a property can be risky, especially if the property in question is their primary residence or source of income.
Let us now examine in more detail certain movable property as collateral.
- Machines or vehicles
Many loans are made against moveable assets that have resale value, such as business-owned machinery or vehicles. The mortgage of movable property to the lender gives access to obtaining a loan, while retaining possession and even using the movable property. . In some cases, this may also involve the transfer of physical possession of the assets to the lender.
- Gold, cash and other valuables
Gold is a common form of collateral, especially in countries like India where many families have a tradition of buying gold or there may be generational gold passed down in the family. Gold bars, coins, and jewelry can be submitted to a lender for a loan, commonly referred to as a gold loan. Other valuables, such as works of art and antiques, can also be pledged, but since it is difficult to assess the true value of these assets and they can fluctuate, the ratio between the loan amount and the actual value of an asset is usually lower. .
Cash collateral refers to money in the borrower’s savings account. Often, a borrower can simply go to the bank where they maintain an active account and leverage the amount in their savings account to take out a loan. In the event of default, the bank can immediately access the account and liquidate it, making it one of the simplest forms of collateral. It also means that the borrower can expect lower interest rates and fees on a secured cash loan.
- Inventory financing and invoice financing
Business owners have two additional forms of collateral available to them that can be used to secure a business loan. These are inventory financing and billing guarantees. Inventory financing refers to the placement of company stock or inventory that is not intended for immediate sale as collateral. In the event of default, the lender can seize and liquidate inventory to recoup losses.
Invoice financing, on the other hand, involves submitting unpaid invoices or orders as collateral in exchange for a loan. This is done in the hope that the payments will be made in due time and will serve as repayment of the loan. This helps companies regulate their cash flow and maintain stability in their operations.
- Investment guarantee or securities
Personal investments in financial instruments such as stocks, bonds, and mutual funds, also known as securities, are another form of asset that can be used as collateral to secure a loan, depending on the lender’s policy. This form of collateral is more commonly used to secure business loans and a line of credit. Even during loan repayment, the securities portfolio remains under the borrower’s control and the borrower can continue to benefit from the returns.
Although this form of collateral, like cash, has the advantage of being easily liquidated by the lender in the event of default, it carries an additional degree of risk. Indeed, the value of these assets can fluctuate according to market movements and is therefore less reliable than that of cash or real estate guarantees. If the value of the investment declines beyond the amount borrowed, the borrower could be required to pay the balance to the lender even after the assets have been repossessed.
What happens in the event of a defect?
While lenders typically work with borrowers to reduce the risk of a secured loan defaulting, if this occurs the lender may undertake the process of repossessing and liquidating the pledged assets to partially or fully recover their losses. . In the case of a mortgage, the process of the lender taking possession of the property is called foreclosure.
As much as this process can be an ordeal for the borrower, lenders may be less keen on initiating it as well, as it is a time-consuming and expensive process.
- Typically, the lender will issue multiple notices to the borrower and offer a grace period to catch up on past due payments before considering a nonpayment or missed equal monthly payment (EMI) a default.
- They could also resort to alternatives such as mortgage relief, modification of loan conditions or partial amortization.
- If all else fails and the loan is deemed a non-performing asset (NPA), which is usually after a 90-day period or three missed EMIs, the foreclosure or repossession process is triggered and ownership of the assets is claimed by the lender.
Collateral is a proven and widely used form of collateral for acquiring loans and it offers the benefit of lower risk for lenders and better loan terms for borrowers. However, the lack of collateral prevents many from accessing credit that can help them improve their lives by expanding their business, seeking educational opportunities or being able to buy a house.
This is especially true for last mile borrowers who do not have assets that can serve as collateral or who lack formalization and understanding of the complicated paperwork required of them.