Definition of Collateral
Collateral is an asset (for example: a building, land, etc.) belonging to a borrower that acts as a guarantee to the lender, in order to secure a loan. For example, if a borrower wanted £50,000 to start a limited liability business, a bank would be reluctant to lend to lend the money, even if the borrower has a good personal credit rating with the bank, as it is a new venture, and thus innately risky. Specifically, if the borrower chose to default on the loan, then the bank would have no recourse to recoup the money from the borrower's personal funds, given the ring-fencing of those under the legal structure of a 'limited liability' company. In order to mitigate all or some of this risk, the bank may require the borrower to pledge £50,000 of specific assets ('blue-chip' shares, property, jewellery, vehicles, owned by the borrower, for example) to the bank, to be taken by the bank in the event that the borrower fails to honour the debt repayment. According to the terms of the loan agreement, a lender and borrower will determine the trigger points at which collateral may be seized and then sold by the lender (for example, one missed debt repayment) or may instead choose to impose further financial penalties on the borrower (such as ballooning interest rates after a certain period of time of non-repayment).