Glossary
Collateral
An asset pledged to secure a loan, which the lender may take if the borrower fails to repay.
Collateral is property a borrower pledges to a lender as security for a loan. If the borrower defaults, the lender can seize and sell the collateral to recover what it is owed. Because it reduces the lender's risk, a secured loan usually carries a lower interest rate than an unsecured one. Collateral runs through everyday finance, from mortgages and car loans to margin accounts and the trillion-dollar markets where banks and funds borrow against securities.
How it works
Lenders rarely lend the full value of the collateral. They apply a haircut or, equivalently, a maximum loan-to-value (LTV) ratio, leaving a cushion in case the asset's value falls.
Where it matters for investors
- Collateral value moves. When markets fall, the value of pledged securities drops just as borrowers most need it, which can force selling and deepen declines.
- Quality counts. Lenders apply larger haircuts to volatile or illiquid assets; Treasury bills receive small haircuts, small-cap stocks large ones.
- Secured versus unsecured bonds. Bonds backed by specific collateral generally recover more in a bankruptcy than unsecured bonds of the same issuer.
- Derivatives. Futures and many swaps require posting collateral (margin) that is adjusted daily as prices move.