What role does collateral play in loan agreements?

Collateral is an asset or property that a borrower offers to a lender to secure a loan. When a loan is secured by collateral, it provides the lender with assurance that, in the event of default by the borrower, the lender has a claim to the collateral to recover the unpaid amount. This reduces the risk for the lender since they can potentially repossess the collateral, such as a car or a house, if the borrower fails to repay the loan. As a result, loans that are secured with collateral often have lower interest rates compared to unsecured loans, as the risk for the lender is mitigated.

The other options do not accurately represent the function of collateral in a loan agreement. For instance, collateral does not change the loan amount, and it certainly does not replace interest payments or eliminate the need for credit checks, as lenders still assess the borrower’s creditworthiness before issuing a loan.