What is collateral and why do banks ask for it?

Every industry has unique words, terms and phrases. In the financial world, you may have encountered the word collateral or security when you visit your bank for a loan; but what exactly does this mean and why do banks ask for collateral?

Collateral refers to something of meaningful financial value which you as a borrower may be asked to provide to a bank when a loan is granted to you. In the event of you not being able to honour the repayments on the loan, the bank may then use your collateral as a means to settle the outstanding debt, says Athalia Wallace-McNab, senior compliance officer at Bank Windhoek's Collateral and Compliance Department.

Collateral provides additional assurance to the bank that you intend honouring your payments. As such, the collateral is a way for the bank to mitigate the risk of unpaid loans or when you encounter an unfortunate change in circumstance, which influences your repayment ability. Building collateral also unlocks value for you as a borrower, as you may use the current value of your assets to obtain funding from a bank, which you may in turn use to obtain or improve your assets; in essence a tool for wealth creation, said Wallace-McNab.

There are different types of collateral security you may provide. The two most common types are cessions and Mortgage Bonds. A cession is a legal document whereby you transfer your rights in an asset to the Bank for a specific reason such as a loan. You may use property such as an Insurance/Life Policy, investments in entities such as shares in a private or publicly listed company, unit trusts, money held in notice deposit and savings accounts, and even your debtors' book if you sell goods on credit.

Mortgage Bonds can be used as collateral if you buy or already own property such as a flat, house, plot or farm, or even a boat, you may offer to register a suitable mortgage bond to the bank.

Financial institutions, such as Bank Windhoek, play a vital role in the economic growth and development of the country. By making use of your assets as collateral, you as a borrower is empowered to unlock further value and obtain Bank funding to increase or improve your assets and to build your wealth, Wallace-McNab concluded.

Source: New Era Newspaper Namibia