Why do Banks or Lenders Demand Collateral Against Loans?

Hey Pal,

After bagging a new job, I wanted to buy a new car. As a result, I planned to avail myself of a car loan. I was not having any idea of mortgage or collateral previously, however, when I visited the nearest bank branch, I enquired, “why do banks or lenders demand collateral against loans?” To this, the bank manager explained what is collateral and how it works. I would be happy enough to explain the same to you guys.

What do you mean by Collateral?

An asset that a lender accepts as collateral for a loan is referred to as collateral. Depending on the loan's purpose, collateral may be in the form of real estate or other forms of assets. For the lender, the collateral serves as a type of insurance. In other words, if the borrower misses a payment on the loan, the lender may sell the collateral to collect some or all of its losses.

Why do banks ask for collateral while giving loans:

Lenders want to be sure that you have the means to pay back any loans before they give them to you. Because of this, many of them need security of some kind. Collateral is a type of security that lowers the risk for lenders. It aids in ensuring that the borrower fulfils their financial commitment. If the borrower does fall behind on the loan, the lender has the right to seize the collateral, sell it, and use the proceeds to cover the outstanding balance. In order to recover any outstanding balance, the lender may decide to file a lawsuit against the borrower.

As previously stated, collateral can take many different forms. It usually has to do with the type of loan; for example, a mortgage is secured by the residence, whereas a car loan is secured by the vehicle in issue. Other assets may be used as security for other unsecured personal loans. For instance, a cash deposit equal to the credit limit could be used to obtain a secured credit card.

Collateral-backed loans frequently have interest rates that are much lower than those of unsecured loans. Because they risk losing their home or other assets used as collateral if they don't make their payments on time, the borrower has a strong incentive to pay back the loan.

I hope this answer satisfies your query of “why do banks or lenders demand collateral against loans?” I hope this helps:)

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