Difference Between Primary Security and Collateral Security

Explore a wide range of Working Capital and Business Loan offerings. Open a Current Account now

Home

Services

Products

Help

Get App

difference between primary and collateral security

Did you know that contrary to popular belief, there is a distinction between primary and collateral security? But before we get to that, it's essential to grasp the concept of security itself. In financial terms, security refers to an asset a borrower provides to a lender to secure a loan or credit facility. This asset is a form of guarantee, mitigating the lender's risk in case the borrower defaults on the loan repayment.

Security can take various forms, each serving a specific purpose in the lending process. Two common types of security are primary and collateral security, each playing a distinct role in securing financial transactions. Let's explore the definition and meaning of primary and collateral security to understand their differences effectively.

What is Security?

In banking, security encompasses measures taken to mitigate risks associated with lending and financial transactions. While security in general parlance implies protection, in banking, it refers to safeguards put in place by financial institutions to ensure the repayment of loans and advances. Banks play a crucial role in providing funds to individuals and businesses, and to safeguard their interests, they require borrowers to provide security against the loans granted.

Security in banking is twofold, consisting of primary security and collateral security. Primary security refers to the main asset or guarantee the borrower provides to secure the loan. It serves as the primary source of repayment in case of default.

On the other hand, collateral security acts as secondary security, supplementing the primary security to mitigate the lender's risk further. In the event of default, the bank has the right to claim the assets provided as security by the borrower to recover the outstanding debt.

Also Read: What is Unsecured Business Loan?

Key Differences between Primary and Collateral Security

Aspect	Primary Security	Collateral Security
Definition	Security directly linked to the loan or obligation	Security provided as a secondary source of repayment
Priority of Repayment	Given priority in repayment over collateral security	Repaid after primary security in case of default
Relationship to Loan/Obligation	Directly tied to the loan or obligation	Indirectly linked to the loan or obligation
Liquidation Process in Default	Immediately liquidated in case of default	Liquidated after primary security in case of default
Examples	Real property in mortgage loans, cash deposits	Stocks, bonds, vehicles, and equipment are pledged as collateral
Legal Implications	Higher legal priority in case of bankruptcy or default	Lower legal priority compared to primary security

A. Priority of repayment:

Primary Security: Given precedence in repayment over collateral security, ensuring immediate satisfaction in case of default.
Collateral Security: Repaid after primary security in default scenarios, with secondary priority in repayment.

B. Relationship to the loan or obligation:

Primary Security: Directly tied to the loan or obligation, serving as the main asset linked to the financing.
Collateral Security: Indirectly linked to the loan or obligation, providing additional assurance beyond the primary security.

C. Liquidation process in default scenarios:

Primary Security: Immediately liquidated in case of default, facilitating prompt repayment to the lender.
Collateral Security: Liquidated after primary security, ensuring repayment but with secondary consideration in the event of default.

D. Legal implications and rights of creditors:

Primary Security: Holds higher legal priority in bankruptcy or default situations, ensuring creditors' rights are safeguarded with precedence.
Collateral Security: Possesses lower legal priority compared to primary security, offering creditors secondary rights and remedies in case of default.

Types of Security

Let's learn about primary security and collateral security in detail.

What is Primary Security?

Primary security refers to the specific assets directly associated with a loan transaction and pledged by the borrower to secure the financing the lender provides. These assets serve as the primary source of repayment in the event of default, offering a guarantee to the lender against the risk of non-repayment.

Examples of primary security include assets directly financed by the loan. For instance, in the case of a housing loan, the property being financed (the house) serves as the primary security. Similarly, in a term loan for machinery, the machinery being financed becomes the primary security.

Characteristics of primary security:

Direct relationship with the loan: Primary security assets are closely tied to the loan they are pledged, representing the financed item or project.
Source of repayment: These assets act as the primary source of repayment for the lender in case of borrower default.
Specificity: Primary security assets are identified and agreed upon between the borrower and lender at the time of loan agreement.
Protection against default: By pledging primary security, borrowers provide a tangible guarantee to lenders, reducing the risk of default and ensuring the safety of the loan transaction.

Also Read: Impact of GST on Wholesalers and Retailers

What is Collateral Security?

Collateral security refers to supplementary assets the borrower provides to the lender, in addition to the primary security, to secure a loan. It is a secondary form of security, utilised when the primary security is insufficient to cover the entire loan amount in the event of borrower default.

Types of collateral security include assets pledged by the borrower beyond the primary security to further secure the loan. For instance, in the case of a term loan for machinery purchase, where the machinery serves as the primary security, a commercial plot offered as additional security would be considered collateral security.

Characteristics of collateral security:

Supplementary protection: Collateral finance security acts as an additional layer of protection for the lender, providing further assurance against the risk of default by the borrower.
Secondary in nature: Collateral security is utilised when the primary security is insufficient to cover the loan amount, making it a secondary form of security in loan transactions.
Diverse forms: Collateral lending security can take various forms, including immovable assets like real estate (land, buildings), financial assets (stocks, bonds), or personal assets (vehicles, jewellery).
Risk mitigation: By providing collateral security, borrowers mitigate the lender's risk, enhancing the likelihood of loan approval and favourable terms.
Loan-specific: The requirement for collateral security may vary depending on the type of loan and the perceived risk associated with the borrower's ability to repay. While some loans may require collateral, others, such as micro-credit or instant loans, maybe collateral-free.

Examples of Primary Security and Collateral Security

1. Example of Primary Security:

Let's say you take out a business loan of Rs.40 Lakh to purchase new manufacturing equipment for your factory. The lender requires you to pledge the equipment as the primary security against the loan. In this scenario, the machinery being financed serves as the primary security for the loan.

2. Example of Collateral Security:

Suppose you need funding to expand your business operations and seek a loan of Rs.1 Crore from a financial institution. While the new office building you plan to purchase is the primary security for the loan, the lender also requires additional assurance. As collateral security, you pledge your existing warehouse property, which you own outright, to secure the loan further. In this case, the office building represents the primary security, while the warehouse property acts as collateral security.

Why Collateral Security Is Needed?

Collateral security is essential in specific loan scenarios to bolster lender confidence and mitigate the risk of default. While loans like housing or factory loans are typically secured by the assets they finance, such as property or machinery, collateral security becomes necessary in cash loans. In cash loans, where the borrower's default could lead to asset liquidation, collateral security in the form of immovable property provides an additional layer of protection for lenders, ensuring loan security and repayment even in adverse circumstances.

What Are Collateral-Free Loans?

Collateral-free loans, supported by entities like CGTMSE, offer lending without collateral requirements, aiding enterprise growth. They enhance accessibility for micro and small businesses, simplify loan processing, and promote entrepreneurship. While posing higher risks for lenders, credit guarantee schemes mitigate these risks. The policy resolves funding challenges and encourages economic development.

Kotak Mahindra Bank also provides collateral-free Business Loans of up to Rs.1 Crore to MSMEs looking to expand or manage their operations. Check the eligibility on the Kotak website and apply now!