What is the primary purpose of collateral in a loan agreement?

The primary purpose of collateral in a loan agreement is to secure repayment in case of default. When a borrower provides collateral, they offer an asset that the lender can claim if the borrower fails to repay the loan as agreed. This reduces the lender's risk, as they have the ability to recover their funds through the sale of the collateralized asset. The inclusion of collateral helps lenders feel more confident in extending credit since it provides a safeguard against potential losses.

This mechanism is vital in lending practices as it ensures that there is a tangible asset backing the loan, which can facilitate access to credit for borrowers, especially those who may not have strong credit histories or who are seeking larger loan amounts.