What is a Collateral Agreement?

A collateral agreement is a type of financial contract that is sometimes established between a lender and a debtor. The terms of the debt agreement will vary, but in most cases the idea is to pledge certain assets in the possession of the debtor to the balance of the debt. This allows the lender to claim those assets in the event that the debtor fails to honor his or her debt obligations. Collateral agreements are also sometimes utilized in situations that involve the settling of an outstanding debt with a tax agency.

When used as part of a lending situation, a collateral agreement establishes the right of the lender to have a claim on certain assets owned by the debtor for the duration of the loan period. Should the debtor make payments on the balance according to the schedule found in the terms and conditions of the loan, the lender does not exercise this option and the debtor continues to have use of those assets. In the event that that the debtor should fail to make those payments according to the repayment schedule, the lender may choose to seize control of those assets as a means of recovering the balance due on the loan, plus any expenses associated with the collection effort. If at the time that the assets are seized, the resale value does not equal the balance of the debt, the lender is free to seek other means of recovery for any remaining balance due on the loan.

Another example of a collateral agreement is connected with the payment of past due taxes. In some instances, this is known as a future income collateral contract. Essentially, the terms of the agreement allow the tax agency to lay claim to a specific percentage of the taxpayer’s anticipated annual income. From there, a payment schedule is worked out in which a portion of the monthly pay is forwarded to the tax agency until the tax debt plus any applicable interest and penalties is settled in full. Depending on the circumstances, the collateral agreement may be worked out between the agency and the taxpayer. At other times, the intervention of a court may be necessary.

Typically, a collateral agreement helps to reduce the degree of risk that a lender takes on by granting a loan to the debtor. The assets that are pledged as collateral must be determined to have a market value that is at least as much as the total amount of the debt. Depending on the specific circumstances and trade regulations that may apply in the jurisdiction in which the loan is granted, the collateral may have to hold a market value that is slightly more than the face value of the loan. This helps to protect the lender from the potential of some sort of depreciation on the collateral, such as falling property values during a recession.