Collateralization

You want a loan to start a business, and you want a low interest rate. No one just gives you money without an obligation. So, to get a loan of $50,000 to get started, you must put up collateral in the event that you default. If you default, the lender gets the asset.

This blood oath...nay, pledge...to honor your debt by handing over this asset is the process of collateralization.

Collateral could be anything of value that the bank can use to protect its investment. It could be a car, artwork, a baseball card collection, even your company’s inventory, should you default. Collateralization allows the lender to seize these assets and sell them in order to recoup the rest of your balance. The most common form of collateralized loans are mortgage loans, since the actual house becomes the collateral in the event of default, and ultimately foreclosure.

There is good news though. Collateralized loans typically have lower interest rates than non-collateralized loans, due to the reduction of risk for the lender.