Lenders ask for collateral while lending primarily to reduce their risk in case the borrower fails to repay the loan. Collateral is an asset owned by the borrower that acts as a guarantee to the lender. If the borrower defaults on the loan, the lender has the right to seize and sell the collateral to recover the loan amount. This security reassures lenders that they have a way to recoup their losses if repayment is not made. Collateral also motivates borrowers to repay the loan regularly because they do not want to lose the asset pledged as collateral. It allows lenders to provide loans at potentially lower interest rates compared to unsecured loans, as the risk is mitigated by the collateral. Typical examples of collateral include property such as houses (mortgages), vehicles (car loans), business equipment, or other valuable assets. Loans secured by collateral are called secured loans, whereas loans without collateral are unsecured loans. In summary, lenders ask for collateral to:
- Minimize the risk of loan default
- Have a legal right to recoup losses by seizing the asset
- Encourage timely repayment by the borrower
- Offer loans at lower interest rates due to reduced risk
This explanation is drawn from multiple expert sources on collateral and lending practices.
