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What Is Collateral and How Does It Apply to Private Credit?

In Short: Collateral is an asset pledged to a financing provider as a guarantee for repayment of a loan. It is to be forfeited to the financing provider in the event of a default.

When you apply for a loan, you aren’t simply approved based on merit alone. You need to demonstrate to a lender that you have the means and resources that prove you can, in some confidence, pay the loan back. These assets are called collateral.

How collateral works is fairly straightforward. Yet how it applies to private credit investments like those on Percent is a bit different.

How Collateral Works Between Borrowers and Lenders

When a borrower gives a lender collateral, they’re going into a loan with the understanding that if that loan is defaulted, or certain minimum requirements are not met, then some or all of the collateral can be repossessed. The lender then takes the collateralized assets — as part of a lien, or right to keep collateral — to pay off some or all of the original loan. Even after forfeiture of collateral, lenders might still be required to part with additional assets to pay off the remainder of a loan.

Collateral can come in various forms. It could be cash or other liquid assets. It could also be things like real estate or property. The collateral for a car loan, for instance, can be the car itself. Whatever form it may be, collateral is ultimately retained by the borrower unless the borrower reneges their agreed-upon terms with the lender.

Not all loans require collateral. Those that do are called secured loans and typically carry lower interest rates than unsecured loans, or those not requiring collateral.

How This Applies to Private Credit Investments

When you invest in private credit deals (like the ones on Percent), you’re investing in assets like loans or cash advances to businesses and other forms of short-term credit. To receive this credit as part of a secured loan, businesses must put up collateral. Should that business default on the loan, these assets would then be liquidated, sold, or held to maturity in order to generate proceeds to repay the investors in the loan.

It’s worth noting that not all loans on Percent are secured. Like all investments, there is always the risk of losing your principal investment. Yet if one were to invest in a deal involving a secured loan that is defaulted on, investors could eventually receive some or all of their principal back upon the sale/liquidation of the collateral.

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