What is the main purpose of collateral in a loan agreement?

The main purpose of collateral in a loan agreement is to provide security for the lender. When a borrower pledges collateral, they are offering an asset that the lender can claim if the borrower defaults on the loan. This reduces the lender's risk, making it more likely for them to approve the loan, as they have a form of protection should the borrower fail to repay.

Collateral acts as a safeguard for lenders, ensuring that in the event of default, they have recourse to recover the value of the loan through the sale of the collateral. This mechanism is particularly important in larger loans or loans with higher risk. By providing collateral, borrowers may also gain access to better loan terms, such as lower interest rates, but that isn’t the primary function of collateral; the main role is to protect the lender's interests.

While improving a borrower's credit rating or simplifying loan processing can be indirect effects of providing collateral, these are not the primary functions of collateral itself. Collateral mainly addresses the financial risk associated with lending and helps secure the lender's position in the transaction.