The Disadvantages of Collateral for Bonds

Original post by Michael Wolfe of Demand Media

Sometimes, when a person takes out a bond, he is required to put down collateral on the bond, making it a type of secured loan. If the bond is forfeited by the borrower, then the bondholder has a right to seize the collateral as compensation for the forfeiture. While a person who puts up collateral for his bond may qualify for lower interest rates, the practice comes with several disadvantages.

Property Upfront

One of the main problems is that a person who needs to take out a bond -- who is likely in somewhat financially precarious circumstances or lacks much cash on hand, as otherwise a bond would not be necessary -- needs to have enough cash or property on hand to front the collateral. This can be a challenge and may prevent the person from being able to get the bond.

Potential for Loss

Perhaps the biggest problem of putting up collateral is that the borrower risks losing it. If the bond is forfeited on -- and sometimes bonds may have various conditions that make forfeiture easy -- then the borrower may end up losing all of his collateral. When this happens, the value of the collateral may even exceed the value of the money owed on the bond.

Changes in Value of Collateral

Collateral will often not have a fixed value. Instead, the value of the collateral may shift over time, while the bond remains out. This means that the value of the collateral may appreciate. If the collateral appreciates too much, then the person paying back the bond may be exposed for a loss greater than the cost of the bond, putting him at severe financial risk.

Seizure

In some cases, collateral may be forcibly seized. If the collateral is being used by the borrower on a day to day basis, then this represents a severe problem not just financially but logistically. For example, if a borrower puts up his house as collateral and the collateral is seized, then the person may have no place to live.

References

• "Economics"; Roger A. Arnold; 2009

About the Author

Michael Wolfe has been writing and editing since 2005, with a background including both business and creative writing. He has worked as a reporter for a community newspaper in New York City and a federal policy newsletter in Washington, D.C. Wolfe holds a B.A. in art history and is a resident of Brooklyn, N.Y.