What Is Collateralized Lending?

What is Collateralization?

Collateralization is the use of a borrower’s asset to secure a loan. The borrower provides the asset to secure the loan, and if the borrower defaults on the loan, the lender can take possession of the asset and sell it to cover their loss. Providing collateral reduces the default risk, and is often used by borrowers with less than perfect credit. Collateralized loans generally have a lower interest rate than unsecured loans.

Collateralized Borrowing

The two most common types of collateralized loans are home mortgages and car loans. In both events, the lender can repossess the home or car if the borrower or homeowner defaults on the loan payments. Collateralized borrowing is also common for business loans; the business owner will often use property, stocks, or bonds as collateral for the loan. In the event that the business defaults, the underwriters can seize the collateral assets, sell them, and repay investors.

The increased level of security offered through collateralization typically lowers the interest rate offered on the loan, which decreases the cost of financing. The principal amount of a collateralized loan is typically based on the appraised collateral value of the property. Most lenders will loan between 70% and 90% of the value of the collateral.

Collateralized Investing

Securities and currency are commonly used as collateral in investing. Margin buying is often based on the use of collateral. If an investor has enough assets in their portfolio, a brokerage firm will allow them to buy securities with borrowed money. The assets in the investor’s account serve as collateral. The loan is repaid with the profits from the purchase. Losses are covered by a sale of the collateral assets. Brokerages typically require the margin calls, or the amount of securities or currency used as collateral, be equal to a percentage of the total amount borrowed. Investors can also use margin trading to short sell assets including bitcoin.

Using Bitcoin as Collateral

Traditional and cryptocurrency-focused financial institutions have begun offering customers the option to use bitcoin as collateral for a USD loan. While the borrower is making payments on the loan, the lender takes custody of the bitcoin collateral. Once the loan is paid off, the client receives custody of their bitcoin, including any increases in value that occurred during the loan period.

Using bitcoin as collateral allows the borrower to access the value of their bitcoin without having to sell. Depending on the loan agent and custodian, using bitcoin as collateral most often does not trigger a capital gains tax. In some cases, interest payments on the loan can be tax deductible.