Collateral is a protection provided by a third party to ensure the fulfillment of certain obligations between two parties. In the banking and financial world, collateral is an important instrument used to reduce the risk of default or failure to repay. This collateral provides assurance to the guarantee recipient that if the guarantor fails to fulfill their obligations, the third party will bear some or all of the resulting losses.
So, what do you need to know about credit collateral? What are the types of credit collateral? Let’s find out in this article.
1. Definition of Collateral
1.1 Understanding Collateral
Collateral is a written commitment provided by a third party, such as a bank or financial institution, to another party to ensure the fulfillment of certain obligations. This collateral provides assurance to the guarantee recipient that if the guarantor fails to fulfill their obligations, the third party will bear some or all of the resulting losses.
Collateral can take various forms, depending on the type of transaction and the needs of the parties involved. Some examples of collateral include bank guarantees, securities, property, vehicles, or other valuable items.
1.2 Functions of Collateral
The function of collateral is to provide protection or assurance to the guarantee recipient in business transactions. Some functions of collateral include:
- Minimizing Risk: Collateral is used to minimize the risk of failure or default from the guarantor. With collateral in place, the guarantee recipient has protection if the guarantor fails to fulfill their obligations.
- Increasing Trust: Collateral can increase trust between parties involved in the transaction. The guarantee recipient has confidence that if there is a payment failure or contract violation, they will receive compensation or payment from the guarantor.
- Facilitating Loans: Collateral is also used in loan transactions to provide assurance to the lender. With collateral, the lender has the certainty that if the borrower cannot repay the loan, they can seize the provided collateral.
- Enhancing Credibility: Collateral can enhance the credibility of the guarantor in the eyes of other parties. The guarantee recipient has confidence that the guarantor has the capability and commitment to fulfill their obligations.
2. Types of Credit Collateral
In credit transactions, there are two main types of collateral used: personal collateral and tangible collateral. Here is a further explanation of these two types of collateral:
2.1 Personal Collateral
Personal collateral involves an individual acting as the primary guarantor in a credit transaction. In this case, the individual personally guarantees the payment obligations arising from the credit. Some forms of personal collateral include:
- Personal Guarantee: A personal guarantee involves self-guaranteeing, where the individual acts as the direct guarantor for the credit payment obligations.
- Third-Party Guarantee: In some cases, individuals can obtain guarantees from third parties, such as family members, relatives, or close friends, who are willing to act as guarantors in the credit transaction.
2.2 Tangible Collateral
Tangible collateral involves the use of physical assets as collateral in a credit transaction. This collateral gives the creditor the right to seize the asset if the debtor fails to fulfill their obligations. Tangible collateral itself has its types.
3. Types of Tangible Credit Collateral
3.1 Warehouse Receipts
Warehouse receipts are proof of ownership of goods stored in a warehouse. This gives the receipt holder the right to retrieve the goods or use the receipt as collateral to obtain a loan.
The working mechanism of warehouse receipts is that goods stored in the warehouse will be supervised by an independent third party. After that, the warehouse will issue warehouse receipts that can be used as collateral. The loan value is usually based on the value of the stored goods.
Using warehouse receipts as collateral allows the owner to obtain liquidity without having to sell their goods. This is very useful for companies with business cycles involving long stock periods, such as agriculture or commodities.
3.2 Letter of Credit (LC)
A letter of credit (LC) is a document issued by a bank that guarantees payment to the seller for exported goods if the buyer or importer fails to make the payment.
LCs are widely used in international trade to reduce risk between buyers and sellers who are not familiar with each other. With an LC, the seller feels more secure because the buyer's bank guarantees payment.
One of the advantages of an LC is its flexibility in adapting to various types of transactions and payment terms. LCs also help speed up the payment and shipping process as the bank is directly involved in the transaction.
3.3 Bank Guarantee
A bank guarantee is a written commitment issued by a bank to pay a certain amount of money to a third party if the client who obtained the guarantee fails to fulfill their obligations. This is a very popular form of collateral in business transactions because of the high level of trust in banks.
Bank guarantees can be categorized into several types depending on the purpose and specific conditions of the guaranteed transaction. Some examples include bid guarantees, performance guarantees, maintenance guarantees, and payment guarantees.
With a bank guarantee, the borrower does not need to provide physical assets as collateral. This allows the borrower to maintain liquidity and reduce the risk of losing assets in case of default. Additionally, bank guarantees often enhance the borrower's credibility in the eyes of other lenders.
3.4 Securities and Stocks
Securities and stocks are liquid assets that can be traded in the capital market, making them an attractive collateral option for individuals with an investment portfolio. A diversified investment portfolio, including various types of securities and stocks, can provide better protection as collateral. Diversification reduces the risk concentrated on a single asset or sector and can enhance the portfolio's attractiveness as credit collateral.
Securities such as corporate bonds or government bonds can be strong credit collateral because they often offer higher security compared to other types of investments. They also often offer the benefit of regular interest payments.
On the other hand, publicly traded company stocks offer flexibility as collateral because they are easily tradable. However, stock values can be very volatile, so it is important to choose stable stocks with a good performance history.
3.5 Deposit Certificates
Deposit certificates are proof of funds deposited in a bank that have a stable value and can be quickly liquidated, making them highly liquid collateral.
Deposit certificates are considered safe assets because they are backed by the bank and often guaranteed by deposit insurance institutions. This provides a higher level of confidence for lenders regarding the reliability and security of the collateral.
One of the main advantages of deposit certificates is the ease of liquidation. In many cases, the holder of a deposit certificate can quickly cash out their funds, meaning the lender can recover the loan funds more quickly in case of default.
It is important to check the maturity period of deposit certificates when using them as collateral. Choosing certificates with shorter terms or those that can be liquidated before maturity can provide more flexibility for the borrower and lender.
3.6 Machinery
Machinery and heavy equipment are often used as collateral for loans in the business world, especially in manufacturing and construction industries. The high value of machinery makes it a good asset to collateralize.
Banks will appraise machinery based on its condition, age, and current market value. This appraisal is important to determine the loan amount to be provided.
3.7 Motor Vehicles
Types of Credit Collateral Image Source: Freepik
Motor vehicles, such as cars and motorcycles, are often used as collateral because of their relatively high value and ease of resale. Vehicles chosen as collateral should be in good condition to maintain their value.
The first type of motor vehicle is a car. Cars often have significant value and are easy to appraise, making them common collateral. The value of a car can be checked through various sources, such as price guides or professional dealer appraisals.
The next type of motor vehicle is a motorcycle. Motorcycles can also be used as collateral, especially if they have good resale value. Rare or limited edition motorcycles often have higher value as collateral.
Non-bank financial institutions such as BFI Finance use motor vehicles as collateral in financing applications. The documents used as collateral are the Vehicle Registration Certificate (BPKB) of the motorcycle or car.
3.8 Property
Property, such as houses or land, has a value that tends to increase over time and is often a desirable collateral for lenders due to its immovable nature and substantial value.
One type of property is a house. A private house can be a very valuable credit collateral. House values usually increase over time, and this asset is often considered a stable investment. It is important to ensure that the house is not already being used as collateral for another loan or in a mortgage condition.
Additionally, there is land. Land is a rare asset and often increases in value. If not burdened with debt or legal disputes, land can be an excellent collateral because of its constant demand and rising prices.
The common property documents used as collateral are house certificates. Both banks and non-bank financial institutions, such as financing companies, use house certificates as collateral for debtors in financing applications.
Sobat BFI, here is what you need to know about credit collateral for your loan. If you have valuable assets and need additional funds, BFI Finance can be your solution. BFI Finance is a financing company that offers multipurpose loans with motorcycle BPKB, car BPKB, and house or shop certificates as collateral for your various needs. BFI Finance offers loans with low-interest rates and disbursement in just 2-3 days. Apply for your loan now, only at BFI Finance.
