Collateral

Also called: Security, Security for loans · Topic: Rural Credit, Microfinance and Financial Inclusion · NCERT: Class 10, Ch 3 "Money and Credit"; Class 11, Ch 5 "Rural Development"

Meaning

Collateral is an asset that a borrower owns, such as land, a building, a vehicle, livestock or bank deposits, and pledges to the lender as a guarantee until the loan is repaid. If the borrower defaults (fails to repay), the lender has the right to sell the asset and get the money back.

It matters because banks mostly lend against collateral and documents. Many poor rural households have no land title and no deposits, so they cannot offer collateral. Class 11 (Rural Development) says this left a "vast proportion of poor rural households... automatically out of the credit network", and they were pushed towards moneylenders.

Explanation

How collateral works

• Credit (a loan) is an agreement. The lender gives money now, and the borrower promises to pay it back later.
• Collateral is one of the four terms of credit (the conditions of a loan):
• interest rate: the extra amount paid on top of the principal (the amount borrowed);
• collateral: the asset pledged as a guarantee;
• documentation requirement: papers such as salary proof, land records or identity documents;

• mode of repayment: for example monthly instalments, one payment after harvest, or payment in crop or labour.

• The steps:

• the borrower pledges an asset and gets the loan;
• while the loan is unpaid, the lender keeps a claim on the asset, and often keeps its papers too;
• if the loan is repaid in full, the asset or its papers go back to the borrower;
• if the borrower defaults, the lender can sell the asset to recover the money.

Why lenders ask for collateral

• The lender cannot be sure of repayment.
• Collateral moves the risk from the lender to the borrower.

• If the loan goes bad, the lender still has something to sell.

• It makes the borrower more careful.

• The borrower does not want to lose the land or house.

• So they try harder to repay on time.

• Better collateral usually means easier terms. A salaried person with a house usually gets lower interest and softer terms. A landless labourer with no papers often gets the worst terms, or no loan at all.

Types of collateral

• Immovable property (land or a house). When this is used as security, it is called a mortgage.
• Movable assets: gold, livestock, vehicles and bank deposits. These can be collateral, but they cannot be "mortgaged".

Worked example: Megha's housing loan (Class 10)

Term	Megha's loan
Loan amount	₹5 lakh
Duration	10 years
Interest rate	12% per year
Documents	Employment records and salary proof
Mode of repayment	Monthly instalments (EMI)
Collateral	Papers of the new house, returned only after full repayment

• EMI (Equated Monthly Instalment) is the same fixed amount paid every month. Each payment covers part of the interest and part of the principal. This formula is for illustration and is not in NCERT:
• EMI = P × r × (1+r)^n ÷ [(1+r)^n − 1]
• P = ₹5,00,000; r = 12% ÷ 12 = 0.01 a month; n = 120 months
• (1.01)^120 ≈ 3.3004, so EMI ≈ 5,000 × 1.4347 ≈ ₹7,174 a month

• Total repaid ≈ ₹8.6 lakh, of which interest ≈ ₹3.6 lakh

• Lesson: Megha gets a formal bank loan because she has a salary slip (a document) and a house (collateral). A poor rural borrower has neither.

In India

• Who is left out. Banks lend against collateral and documents. The rural poor usually have:
• no land title, because they are tenants, sharecroppers or landless;
• no salary slip, because their income is irregular, daily and in cash;

• no deposits to pledge.

• Why banks hesitate with small farmers:

• a small plot gives little collateral;
• a small loan has a high processing cost per rupee lent, since the paperwork is about the same for a small loan as for a large one;

• farm income depends on the monsoon, so the risk is high.

• Scale of the problem. In the Agriculture Census 2015-16, small and marginal holders were about 86% of all operational holders [7]. NCERT's Class 10 exercise says "about 80 per cent".

• Result: the poor go to informal lenders such as moneylenders, traders and landlords.
• They ask for little paperwork but charge very high interest.
• They may demand land, crops or labour as repayment.
• The RBI does not regulate them.

• Illustration with assumed numbers: ₹10,000 for one year from a moneylender at 3% a month (compounded) costs about ₹4,258 in interest. The same loan from a bank at the effective 4% allowed under the Modified Interest Subvention Scheme [2] costs about ₹400. That is about 10 times less.

• RBI rule on collateral-free farm loans:

• The limit was ₹1 lakh in 2010. RBI raised it to ₹1.6 lakh on 7 February 2019. Banks may also waive the margin (the borrower's own share of the cost) up to this limit [3].
• From 1 January 2025, banks must waive both collateral and margin for farm loans, including loans for allied activities, up to ₹2 lakh per borrower. The reasons given were inflation and the rising cost of farm inputs [2].

• RBI links this relief to small and marginal farmers, who are over 86% of farmers [2].

• Access to credit still follows land (NAFIS 2021-22, a NABARD survey of 1 lakh rural households):

• 44% of farm households had a valid Kisan Credit Card (KCC), a bank card that gives farmers short-term crop credit [4].
• Among those with more than 0.4 hectare, or who had taken a bank farm loan in the past year, 77% had a KCC [4].

• So households with more land, and therefore more collateral, get much better access to formal credit.

• Removing the paperwork barrier: PMJDY (2014). Pradhan Mantri Jan Dhan Yojana tackles documentation more than collateral:

• A Small Account (Chhota Khata) can be opened without legal documents and is valid for 12 months [5].
• Account holders get an overdraft of up to ₹10,000 [5]. An overdraft is the right to withdraw more than the balance, so it works as a small loan.
• There were 56.16 crore accounts by 13 August 2025 [6].

Don't confuse with

• Mortgage: this is only one kind of collateral. A mortgage always uses immovable property (land or a house). Gold, livestock or a vehicle can be collateral, but they are not "mortgaged".
• Margin: this is the borrower's own share of the cost of what the loan pays for. It is not an asset pledged to the lender. RBI rules waive both collateral and margin up to ₹2 lakh [2].
• Documentation requirement: these are the papers that prove who you are and what you earn, such as a salary slip or land records. Collateral is an asset that the lender can sell. PMJDY relaxed documents, but it does not remove the need for collateral on larger loans.
• Interest subvention: this lowers the price of a loan, because the government pays part of the interest (effective 4% on crop loans up to ₹3 lakh) [2]. Collateral-free lending lowers the security a borrower must offer. The two limits (₹3 lakh and ₹2 lakh) are different.

Prelims Hooks

• Terms of credit = interest rate + collateral + documentation requirement + mode of repayment (Class 10, Money and Credit).
• A mortgage uses immovable property. Trap: "livestock is mortgaged" is wrong. Livestock can be collateral, but it cannot be mortgaged.
• The collateral-free farm loan limit went from ₹1 lakh (2010) to ₹1.6 lakh (7 February 2019) [3], then to ₹2 lakh per borrower from 1 January 2025, with margin also waived and allied activities included [2].
• The collateral-free limit (₹2 lakh) and the interest subvention limit (₹3 lakh at an effective 4%) are different numbers [2].
• NAFIS 2021-22 was carried out by NABARD, not the RBI. It found 44% of farm households had a valid KCC, against 77% among larger landholders [4].
• In Megha's Class 10 loan, the house papers were the collateral, and they were returned only after full repayment.

Mains Points

• Lending against collateral deepens inequality.
• Tenants, sharecroppers and landless labourers have no land title, so formal credit goes mainly to people who already own assets.
• The poor are pushed to moneylenders, which can lead to a debt trap: a crop fails, a new loan is taken to repay the old one, and land is lost.

• The KCC gap of 44% overall against 77% among larger landholders shows how closely land and credit are linked [4].

• Raising the collateral-free limit brings trade-offs.

• Gain: easier and cheaper access for small and marginal farmers, who are over 86% of farmers [2].
• Risks: more bad loans (NPAs) for banks, a fiscal cost when the change is combined with interest subvention, and loans being used for non-farm purposes.

• These need careful design and close monitoring.

• Replacing collateral with a track record.

• PMJDY removed the documentation barrier with 56.16 crore accounts (August 2025) [6]. But having an account is not the same as getting affordable credit.
• The next step is to use a person's account history (cash flow) in place of collateral, through the PMJDY overdraft, KCC and Self-Help Group (SHG)-bank linkage.
• As Class 10 says, "cheap and affordable credit is crucial for the country's development".

Related concepts

• Terms of credit
• Cost of borrowing
• Housing loan
• Mortgage

Read more

• Terms of credit: interest, collateral and why the poor are priced out