What is collateral in lending terms?

• A. The principal amount borrowed
• B. An asset pledged by a borrower to secure a loan
• C. The interest rate on a loan
• D. The borrower's credit score

Answer: (B)

Collateral is an asset the borrower pledges to secure a loan. It gives the lender a way to recover funds if the borrower doesn't repay, because the lender can seize and sell the asset to cover the debt. This security often allows for more favorable loan terms, such as larger loan amounts or lower interest rates, compared with unsecured loans. For example, a house serves as collateral for a mortgage, and a car serves as collateral for an auto loan.

In contrast, the principal is simply the amount borrowed, the interest rate is the cost of borrowing, and the borrower's credit score reflects reliability and repayment history—not an asset pledged as security. Collateral can be tangible like property or equipment, or in some cases, other financial assets.