Why Do Banks Use Collateral As a Means to Secure a Loan?

by Melvin Richardson ; Updated July 27, 2017

Collateral is usually some form of property or assets such as equipment, automobiles, tools or real estate that is pledged as security for a loan. Banks will use collateral to make sure they are in a more stable situation when a loan is made.

Significance

If a bank wants to make a larger loan to a consumer or a business, it may require some type of collateral. When a bank has collateral as security, it helps to reduce its risk.

Effects

When a customer defaults on a loan agreement, the bank can repossess or foreclose to take possession of the collateral. Many times the collateral is sold and the proceeds are applied toward the loan balance. Collateral reduces the loss that a bank will incur.

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Appraisal

Banks will sometimes appraise and evaluate the collateral to make sure it can be used as collateral. They don’t want to make a loan for more than what the collateral is worth.

Function

When a bank uses collateral, it will usually file a lien on a mortgage, against the property, with the county courthouse. This information is entered into the public records.

Prevention/Solution

If a customer has a loan and the bank has collateral, the customer must pay off the bank loan from the proceeds of the sale.

Warning

When a customer files a petition for bankruptcy because he has too much debt, he must continue to pay a bank loan if he wants to keep the collateral. If he cannot pay, he must turn the collateral over to the bank.

About the Author

Melvin J. Richardson has been a freelance writer for two years with Associated Content, and writes about topics such as banking, credit and collections, goal setting, financial services, management, health and fitness. Richardson has worked for several banks and financial institutions and gained invaluable experience and knowledge. Richardson holds a Master of Business Administration in Executive Management from Ashland University in Ashland Ohio.

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