If you borrow money, the lender will likely require collateral. Collateral is any asset that can, if the lender agrees, serve as security for the loan. In pledging collateral, the borrower agrees that the lender may legally seize the asset in the event of default (i.e., the borrower fails to repay the loan).
Collateral is motivating for both a lender and a borrower. A borrower is motivated to pay the loan for fear of losing the asset. A lender is motivated to provide the funds because an asset is available in the event of default. Collateral is often the make-or-break issue in securing a loan.
If you borrow to buy a car, the car is collateral for the auto loan. If you borrow (a mortgage) to buy a house, the real estate is collateral for the mortgage. If you borrow to buy stocks (buying on margin), then the securities in your investment account serve as collateral for the loan. If you take out a personal loan, the lender may require you to pledge personal items as collateral. In that case, the collateral and its value are likely to be negotiated.
The interest you pay on a loan is affected by the value of the collateral you pledge. The greater the value of the collateral, the more leverage you have for negotiating the interest rate.
Corporations issue bonds when they borrow money from investors; they may even pledge collateral for some of their bonds (e.g., “mortgage bonds”), while other bonds, called “debentures,” are unsecured.
Often, the lender will have a lien against the collateral, which means that the lender has the legal right to seize the collateral, should the borrower default. While the loan still exists, the borrower cannot sell the collateral without the approval of the lien holder.
THE LESSON
When requesting a loan, be prepared to offer collateral, even if the loan is from a friend or relative. Your offer of collateral is a sign of good faith. A loan that is not backed by collateral is called an unsecured loan, usually backed by the credit history of the borrower. Your character and payment history could be collateral depending on your relationship with the lender. Whether you are the lender or the borrower, make sure there are no other liens on the collateral.
ANY TIME YOU TRY TO WIN EVERYTHING, YOU MUST BE WILLING TO LOSE EVERYTHING.
— Larry Csonka
We defined collateral in financial terms: something you are willing to lose in exchange for what you expect to gain. But consider collateral in human terms. When you put up collateral for a loan, you are making a bet with yourself. The heart and soul of collateral is the negotiation with yourself, not with the lender.
This is the essence of your personal bet: You believe the collateral you are willing to lose will not be lost because the loan will be paid. You also believe that, in the unlikely event you default and lose the collateral, that loss would have been worth it given what you hoped to gain.
We all have heard stories of companies started by founders mortgaging their house, or putting other “skin in the game.” Yes, those would-be entrepreneurs negotiated with lenders; but they ultimately made bets with themselves. To paraphrase Csonka, they were willing to lose to win.
Finally, recognize that if you have a family, they too may have skin in the game, taking risks not of their own choosing. Whenever you ask a spouse or children to bear personal sacrifices because of your financial decisions, you may be creating collateral damage.
The heart and soul of collateral and collateral damage: Consider the potential losses in time, energy, focus and stress you and your loved ones may incur whenever you make that financial bet.
