Understanding Collateral Vs. Security – Auckland Loans
The Auckland loan market is highly diverse, with finance available for various requirements. The basic premise behind any type of finance is based upon the risk/reward ratio and a client’s ability to pay. While the interest rate charged on finance will reflect the risk/reward ratio, there are ways in which you can reduce the perceived risk. One such method is to use collateral or security, which provides the lender with an asset that can be liquidated in the event of default.
Even though the terms collateral and security are often used in tandem, you need to be aware of some subtle differences. It is important to note that not all loans will require any collateral or security because this may not be an option for many people.
What is the concept behind collateral and security?
Before we look at the difference between collateral and security and examples of each, it is essential to remind ourselves of the concept behind collateral/security. When a lender offers finance to a client, the agreement will specify:-
• Loan amount
• Interest rate
• Monthly repayments
While each lender will carry out an in-depth review of the client’s finances before approving a loan, an individual’s financial status can change at any time. Therefore, in order to reduce the risk and protect the loan capital, many lenders will require collateral or security as a failsafe in the event of default. While a last resort, if the client cannot maintain repayments, the collateral/security can be liquidated and the outstanding loan repaid.
What is the difference between collateral and security?
On the first level, collateral and security are both types of assets. However, it can become confusing because security is a type of collateral, but collateral is not a type of security. While interchangeable, there is a marked difference between the two in legal terms. Confused?
We will now take a look at the difference between collateral and security and the role they play in any financial arrangement.
What is collateral?
In basic terms, collateral refers to an asset pledged against the value of a loan. The value must be equal to or greater than the finance made available to underpin the arrangement. Collateral tends to be a tangible asset, i.e. one that you can touch, with property perhaps one of the more recognised types of collateral. However, this is not always the case, as we will cover in a moment.
Under normal circumstances, the collateral value will remain relatively steady with low volatility. Obviously, this cannot be guaranteed as investment trends change, as can supply and demand. However, collateral value is significantly less volatile than the value of a security.
What is security?
In general, lenders tend to consider a broad range of assets when looking to secure finance. One of the more common examples would be a portfolio of stocks and shares. The difficulty with pledging security against finance is the degree of volatility in value compared to collateral. Consequently, you may be asked to provide security valued at more than the outstanding loan – to accommodate a degree of volatility in value. If the value was to fall below the outstanding loan you may be asked to provide additional security.
If we use the example of a portfolio of stocks and shares, recent events with the Covid pandemic are a perfect example. For illustration purposes only, let us assume that you had a portfolio worth NZ$5000 which was used as security against a loan of a similar amount. As we saw, stock markets were extremely volatile in the aftermath of Covid. So let’s say that the value of your portfolio fell by 20%, down to NZ$4000. This leaves a shortfall of NZ$1000 against the value of your loan.
If the client defaults on repayments, a liquidation of the portfolio would leave a shortfall against the loan.
What are the most common types of collateral and security?
While many of us would be able to identify the more common types of collateral/security used, the financial industry is highly flexible. Consequently, the range of collateral and security which may be used to support a loan is considerable. Individual lenders work on different criteria, and it is vital to check that the collateral/security you have available is acceptable.
Types of collateral
While this list is by no means exclusive, whether you are considering a personal loan, car loan or business loan, the following collateral is commonly used:-
• Personal/business real estate
• Personal/business vehicles
• Business equipment/machinery
• Investment accounts
• Paper investments
• Personal/business savings accounts
• Insurance policies
• Equity in your home
• Pay cheques
• Blanket liens
As we mentioned above, there are types of security which are classed as collateral and can appear in both lists.
Types of security
When considering security against a loan, this asset tends to fall into four specific groups, which are:-
• Hybrid securities
On occasion, you will see a mixture of the above types of security used against a loan, for example, a debt and equity combination. Specific examples of security will include any of the following:-
It is not uncommon to use an investment portfolio as security against a loan, including all or any of the above. The main characteristic of a security is the perceived higher degree of volatility compared to tangible collateral.
Is a guarantor a type of security?
Unfortunately, many people seeking financial help may struggle to find suitable collateral/security to help with their loan application. In this scenario, you may be able to turn to a guarantor to guarantee your loan. This is an individual who will take on your debt in the event of default.
In this scenario, a lender may request collateral/security from the guarantor, or their regular income may be enough to secure the finance. This type of arrangement would usually be classed as a type of security because the individual’s financial status may change in the future. Consequently, there is an element of risk if no additional collateral/security is provided.
What happens if you default on your loan?
While all lenders will carry out in-depth research into your financial situation and ability to pay, with the best will in the world, things change. Consequently, if you are struggling with your loan repayments, this can prompt several actions by your lender.
If you are experiencing short-term cash flow issues, with brighter prospects in the medium to longer-term, you may be able to refinance your existing debts. This may involve a new financial arrangement with a longer duration, thereby reducing monthly repayments.
Liquidation of collateral/security
While refinancing may be a possibility for some people, this is not a viable option if you cannot afford repayments in the foreseeable future. Consequently, your lender would need to consider the liquidation of collateral/security to repay the outstanding debt.
Switch debt liability to guarantor
Where a guarantor joined in the original loan agreement, they would be called to honour the outstanding debt in the event of default. In this scenario, monthly repayments will switch to the guarantor until the loan is repaid, or the original applicant can begin repayments again.
It is important to note that liquidating and selling collateral/security or switching liabilities to a guarantor is a last-case scenario for your lender. However, as a responsible lender, there is no point in refinancing your debt if you cannot cover future repayments. On the sale of collateral/security, any surplus funds would be returned to the client after repayment of the outstanding debt and any costs incurred.
Auckland loans that require no collateral or security
While all finance is approved based on a client’s ability to cover repayments, not all loans will require collateral or security. For example, a client may not have collateral or security available, or this may not be the preferred option. This scenario would obviously increase the default risk to the lender, which would be reflected in the interest charge, but unsecured finance is still an option for many people.
If you are searching for Auckland loans that don’t need collateral or security, you can check some of our loan types below:-
You tend to find that unsecured loans are for smaller amounts with a relatively short duration. This is a means of reducing the risk of default, but as with many financial arrangements, the terms are open to negotiation. Consequently, it is crucial to find a lender to suit your specific requirements and financial status.
Collateral and security work for both parties
While much of the emphasis has been on the value of collateral and security to the lender, there is a significant value to the borrower. As all finance is based upon the risk/reward ratio, the lower the risk, the more chance of approval on a relatively low interest rate. Consequently, where a client can offer collateral/security, this is beneficial to both parties.
In tandem with collateral and security, you will also read about secured and unsecured loans. If you would like to know more about this subject, we recommend reading the following article:-
On the surface, the use of collateral or security to obtain finance appears relatively straightforward. It is only when you dig a little deeper and find that security is a type of collateral, but collateral is not a type of security, that it becomes a little more complicated. There is also a common misconception that lenders are quick to liquidate collateral/security if you fall behind on repayments. This is not the case!
There may be the opportunity to refinance existing debt on more affordable terms or consider a short-term repayment holiday. Unfortunately, if a solution cannot be found, as a last resort, the collateral/security would be called and sold to cover the outstanding debt. Consequently, it is essential to recognise that any collateral/security used against a loan is potentially at risk.
by Mark Benson
Mark Benson, a renowned and astute stockbroker/financial adviser spending the majority of his finance-related career operating in the United Kingdom. With 16 years+ experience in the financial sector. he still maintains a strong interest in all things financial. Over the years, he has written about subjects such as property finance, loans, pensions, insurance, stock market investments, tax planning and more. Mark believes it is essential to keep up with the latest financial regulations and adapt your finances accordingly, something he portrays in his financial articles.