What is Collateralization?
Collateralization describes the process in which a loan agreement is secured by a borrower from pledging an asset as collateral. In the event that the borrower defaults, i.e. is unable to service a periodic interest expense payment or mandatory debt repayment per the lending agreement schedule, the lender has the right to seize the collateral.
How Collateralization Works?
Collateralization refers to a financing arrangement wherein a borrower is able to secure a loan by offering collateral to de-risk the lending agreement. Otherwise, the borrower would have been unlikely to obtain the loan or would have received more unfavorable terms.
Since the lender has a rightful claim on the collateralized asset if the borrower were to default – i.e. a lien on the collateral – the lender’s downside is further protected.
Collateralization tends to reduce the interest expense charged by lenders since their risk is lowered by the pledged collateral.
Hypothetically, if the borrower were to default on the loan, the lender has a legal claim on the collateral and can sell it to recoup the outstanding balance of the loan (and recover a portion or the entirety of the original loan amount).
How Collateralization Impacts Interest Rates?
Senior lenders such as corporate banks are far more likely to require collateral as part of the lending agreement, which is the reason the interest rates charged also tend to be lower than yield-oriented lenders such as issuers of high-yield bonds.
- Secured Loan → Lower Interest Rates
- Unsecured Loan → Higher Interest Rates
Because the risk associated with unsecured loans (i.e. subordinated debt) is substantially higher relative to secured loans (i.e. senior debt), the lenders are placed lower in the capital structure and are not protected by any collateral.
In effect, unsecured lenders charge significantly higher interest rates to compensate for the increased risk undertaken by providing financing to the borrower.
In many instances, the lender might demand collateral due to the borrower’s lackluster credit history and risk of default, such as a limited credit history or poor credit score. But in other cases, the lender might be risk-averse and request collateral in exchange for a lower yield, as capital preservation is the lender’s priority rather than achieving the highest yield possible.