Written byCollateral is the property a borrower pledges to a lender as security for a loan, which the lender can sell if the borrower defaults.
Also known as: security property, pledged asset, loan security
Key points
- Typical collateral is the thing being financed: a house, a ute, an excavator, or a business's stock and receivables.
- The lender registers its interest, on the land title for property or the Personal Property Securities Register for goods.
- Lenders advance a proportion of the value, measured by the loan to value ratio, leaving a buffer if prices fall.
- If you default the lender can repossess and sell the collateral, then pursue you for any shortfall.
- Collateral is what separates secured borrowing from an unsecured loan, where nothing specific stands behind the debt.
How collateral works
You and the lender sign a security agreement that identifies the asset. The lender registers its interest so anyone who searches can see the claim. Day to day nothing changes: you keep the asset and keep using it. What has changed is priority. If repayments stop or the business fails, the lender holding a registered interest is paid out of that asset before unsecured creditors get anything.
Lenders also look hard at the asset itself. Value, age, condition and how easily it could be sold all feed into how much they will advance and on what terms. A near new prime mover with an active second hand market is stronger collateral than a specialised machine with few buyers, which is one side of collateral risk.
What lenders accept
Residential and commercial property backs the largest facilities. Vehicles, trucks, trailers, plant and machinery back most business asset finance, usually through a chattel mortgage over the item being bought. Some lenders take a broader charge across company assets, including stock and receivables, rather than one named item.
Not everything qualifies. Assets that lose value quickly, that are hard to identify by serial number, or that already carry another registration are weak or unacceptable. Where a business has little to pledge, lenders lean on trading history and cashflow instead, and company directors may be asked to stand behind the debt personally.
Collateral in Australian finance
Pledging collateral usually improves the terms on offer: larger amounts, longer terms and a lower cost than borrowing on trading record alone. That is why most vehicle and equipment finance in Australia is secured over the item being bought. The arrangement is simple for both sides, because the asset and the debt are tied together from the start.
It cuts the other way too. Tying an asset to a facility limits what you can do with it. Selling it means paying the loan out and having the registration discharged. A second lender can take security behind the first and ranks after it on the register, but most asset finance contracts prohibit granting further security over the same item without the first lender's written consent. Before you sign, check exactly which assets the agreement covers and how the release works.
Example
A landscaping company buys a $90,000 skid steer. The lender advances most of the purchase price, the company puts in the rest as a deposit, and the machine itself is the collateral. The lender registers its interest against the serial number, so any buyer or financier who searches the register can see the claim. Two years on, the company wants to trade the machine in. The dealer asks for a payout figure, the loan is cleared at settlement and the registration is removed, which lets the machine change hands with clear title.
Not to be confused with
- Security (collateral)
- the legal interest the lender holds, where collateral is the property that interest attaches to
- Collateral risk
- the risk the collateral is worth less than expected by the time it has to be sold
Frequently asked questions
What does collateral mean on a loan?
It means a specific asset is pledged to the lender as backing for the debt. You keep using it, but the lender holds a registered interest over it. If you default, the lender can take that asset and sell it to recover what it is owed.
What can be used as collateral?
Property is the usual collateral for home and commercial lending. For business finance it is normally the asset being bought: a vehicle, truck, trailer or piece of plant. Some facilities are secured over stock, receivables or a general charge over company assets.
What happens to collateral if I default?
The lender can enforce its security, which usually means taking the asset and selling it. Proceeds go against the debt, and you stay liable for any shortfall plus enforcement costs. Consumer credit rules require notices before that point, so speak to the lender early about hardship options.
Is collateral the same as security?
They are used interchangeably in conversation, but strictly speaking collateral is the asset and security is the legal interest the lender takes over it. Australian documents and registrations tend to use the word security, while collateral is more common in accounting and international finance.
Can the same asset be collateral for two loans?
Legally yes. A second lender can take security behind the first and ranks after it on the register, recovering only what is left once the first is paid. In practice most asset finance contracts prohibit granting further security over the same item without the first lender's written consent.
Related terms
Security (collateral)
Security (collateral) is an asset or legal interest a borrower grants a lender, which the lender can take and sell to recover the debt if the borrower defaults.
Read definitionCollateral risk
Collateral risk is the chance that an asset pledged as security fails to cover the exposure because it falls in value, cannot be sold quickly or cannot be enforced.
Read definitionAsset
An asset is anything a business or person owns or controls that is expected to produce future economic benefit, such as cash, equipment, vehicles, property or receivables.
Read definitionRepossession
Repossession is the enforced recovery of goods that secure a loan, such as a car, ute or machinery, after the borrower has defaulted on the contract.
Read definitionUnsecured loan
An unsecured loan is credit you borrow without pledging collateral, so the lender relies on your income, credit history and capacity to repay.
Read definitionChattel mortgage
A chattel mortgage is a business loan for a vehicle or equipment: you own the asset from settlement and the lender holds a security interest until it is repaid.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.