Why collateral is important?

Answer 1

Presuming that you're talking about lending terms and conditions, collateral is important for several reasons. First of all, it proves to the lender that you are of good faith and truly believe that you have the both the capacity AND the willingness to repay the debt. You may be able to "talk" a smooth game and convince the lender why you're a good credit risk, but collateral is putting your money where your mouth is, so to speak. It's a trade-off wherein the bank will front you the cash in exchange for pledging an asset of a certain value. It ensures that you, as the borrower, have skin in the game. It provides leverage to the bank if your financial situation gets rough to ensure that you don't walk away from your promise to pay.

Furthermore, conventional banks require collateral because they are fiduciaries of their depositor's money and they operate on very thin profit margins. Banking at its core is taking depositors' checking accounts, savings accounts, and certificates of deposit, and lending that money back out to borrowers. To ensure the safety of those depositor's money, banks require collateral to minimize the risk of principal loss in the event that a loan goes bad. Also, core banking (paying interest to depositors and collecting loan interest from borrowers) has a very thin margin. Typically this is about a 4% margin. So, it is very important that banks are conservative with their lending standards (ie requiring adequate collateral) because losses from only a few bad loans can very quickly eat away their profit margin and start to threaten the safety of their depositor's funds.

These reasons are also why loans with collateral typically bear much better interest rates. Unsecured loans, or loans without collateral, typically have much higher interest rates. For example, credit cards are a form of unsecured loans. They can average anywhere from Prime +5% to Prime + 15% (8.25% to 18.25% as of present date), depending on your credit history and income.

If you deposit your money with a bank, you should expect and hope that they have adequate collateral guidelines in place for borrowing money. Otherwise, you could be one day waiting to get your money back from FDIC insurance proceeds after the bank fails.

Answer 2

Presuming that you're talking about lending terms and conditions, collateral is important for several reasons. First of all, it proves to the lender that you are of good faith and truly believe that you have the both the capacity AND the willingness to repay the debt. You may be able to "talk" a smooth game and convince the lender why you're a good credit risk, but collateral is putting your money where your mouth is, so to speak. It's a trade-off wherein the bank will front you the cash in exchange for pledging an asset of a certain value. It ensures that you, as the borrower, have skin in the game. It provides leverage to the bank if your financial situation gets rough to ensure that you don't walk away from your promise to pay.

Furthermore, conventional banks require collateral because they are fiduciaries of their depositor's money and they operate on very thin profit margins. Banking at its core is taking depositors' checking accounts, savings accounts, and certificates of deposit, and lending that money back out to borrowers. To ensure the safety of those depositor's money, banks require collateral to minimize the risk of principal loss in the event that a loan goes bad. Also, core banking (paying interest to depositors and collecting loan interest from borrowers) has a very thin margin. Typically this is about a 4% margin. So, it is very important that banks are conservative with their lending standards (ie requiring adequate collateral) because losses from only a few bad loans can very quickly eat away their profit margin and start to threaten the safety of their depositor's funds.

These reasons are also why loans with collateral typically bear much better interest rates. Unsecured loans, or loans without collateral, typically have much higher interest rates. For example, credit cards are a form of unsecured loans. They can average anywhere from Prime +5% to Prime + 15% (8.25% to 18.25% as of present date), depending on your credit history and income.

If you deposit your money with a bank, you should expect and hope that they have adequate collateral guidelines in place for borrowing money. Otherwise, you could be one day waiting to get your money back from FDIC insurance proceeds after the bank fails.