Definition of Collateral

Collateral is any asset which is used as backing for debt. In the event of a default on the debt, the collateral is seized to cover the losses. The most common example of collateral is in a mortgage, where the bank uses your home as collateral and in the event that you do not meet your mortgage payments, they have the legal right to seize your home.

One of the problems associated with collateral (which was prevalent in the 2007-2008 subprime mortgage crisis) is that if the collateral asset falls in value below that of the debt, then there is little incentive to pay off the debt. You are better off to default, keep the loan and give up the collateral asset.