With reference to lending, security or collateral, is an asset that is pledged by the borrower as protection in case he or she defaults on the repayment, not paying some or all back.
Under the loan agreement, the lender could have the right to take ownership of the asset in place of the repayment, or he or she might have the right to insist that the asset is sold to repay the outstanding loan and interest (and perhaps other unpaid expenses), with the remainder of the proceeds returned to the borrower.
Security should be important to the lender, whether the borrower is an individual or a company. Without it, the lender might not be able to recover the money lent, however tough the terms of the loan agreement.
What types of assets are commonly used as security?
The lender will want to make sure that the asset is at least as valuable as the outstanding loan, so that if the borrower defaults, the loan can be repaid.
Often the asset that the borrower buys with the loan is used as security. However, some assets (new vehicles being a very good example) devalue immediately after purchase. For these types of purchases, the lender often requires the borrower to make a deposit that reduces the loan amount below the second-hand value of the security.
The lender is also likely to insist on an independent valuation or confirmation of value.
From the lender’s point of view, the more easily the asset can be acquired and sold, the less risky it is to lend against it. Stock may be easy to sell (provided it is not perishable or out of date), where as heavy, fixed specialist machinery may be difficult to acquire from the debtor and difficult to sell on.
The security could be an intangible asset, such as shares in the lending company, or the right to receive a debt owed by someone else. Generally, these are harder to value, and therefore riskier to accept.
We cover in more detail what to choose as security on a loan to a company.
In the UK, a 'lien against real property' in legal jargon – using land and buildings as security – requires a solicitor (for no other good reason than to protect the solicitors’ monopoly on conveyancing transactions). To secure a loan against any other asset, you don’t need a solicitor to be involved.
Some assets may already have be used as security. For example, if a family member is buying a house, and you are lending money for the property's deposit, the mortgage provider will have preferential rights over the proceeds from sale.
If the borrower defaults, the mortgage provider is not under any obligation to sell the property at market value (it just will want the outstanding loan, interest and charges), so you may not receive your loan back. For any given asset, there may be a number of lenders who have preferential rights to be repaid before you, so check who else has a lien.
Guarantors
In addition to securing the loan against an asset, a lender might (we would argue that the lender should) also ask that a company or one or more people act as guarantor. A guarantor gives an additional degree of security. If the borrower defaults, the lender may pursue the guarantor for the whole debt, or any part of it. A guarantor therefore reduces the risk that the second hand sale value of the asset might be less than the debt outstanding.
Further information and documents
You can read further about what terms a loan agreement should contain.
Or you may want to look at our range of loan agreement templates that secure lending to different parties against different types of assets.