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What Is Collateral Security?

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  • Written By: Justin Riche
  • Edited By: A. Joseph
  • Last Modified Date: 22 October 2014
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The term "collateral security" might refer to the safety that a particular asset gives a lender in case a borrower fails to fulfill his or her obligation of making payments. That is, if the borrower can no longer make his or her loan payments as agreed, the lender might take the collateral and sell it to recoup some or all of the money he or she had lent to the debtor. Also, "collateral securities" might refer to financial market securities such as stocks and bonds, because these assets can be used to secure a loan, such as in what is called margin trading. In finance, all sorts of loans can be be backed by any type of collateral security. For example, mortgage loans usually are backed by real estate properties.

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Any type of asset can be used to serve as a collateral security as long as the lender deems the particular asset to be sufficient for his or her purpose. The assets that are accepted as collateral will depend on the particular instance, and as long as the lender thinks that the asset will be sufficient to offset losses if the borrower defaults on the loan. For instance, a lender might extend a loan to a company with a particular expected business cash flow as the collateral security for the loan. That is, if the company sells particular goods or services to a customer but then has to wait for a while before the customer can pay the bill, the company might choose to borrow against that particular expected cash flow if it needs the money immediately.

Certain brokerage houses allow traders to deposit some type of collateral security in a margin account, which is a specific account for this kind of activity. Generally, the collateral securities used in this type of transaction are stocks or bonds owned by the trader. One of the main reasons for this transaction is so that the trader can borrow money from the broker to buy more securities, and the loan is secured by the collateral in the margin account.

When one gets a mortgage, the piece of property being purchased will serve as the collateral for the loan. For example, individuals and businesses get loans so they can purchase real estate properties, automobiles, land, equipment or other types of assets necessary to live or conduct business. In any one of these loan situations, the ownership of the properties, automobiles, land and others can be transferred from the borrower's name to the lender's name if the borrower fails to meet his or her obligation. Then the lender can turn around and sell the assets so that he or she can recover his or her money. Other collateral assets that might be used to secure loans include valuables such as jewelry, antique coins and gold bullion.

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