To minimize the credit risk, banks and other lenders often obtain some form of security in the form of collateral, before giving any credit or loan. The term collateral refers to some asset that an entity surrenders as a security to borrow funds. Collateral is seized and sold by the lender to make up for the loss suffered by the lender if the entity (creditor) defaults in paying the amount due to the lender.
Based on the presence or absence of such collaterals, payables are classified into two categories.
- Secured payables
- Unsecured payables
A payable that is backed up by some collateral is known as secured payable. In case of default by the borrower or creditor, collateral is seized and sold by the lender to make up for the credit loss.
Companies prefer to obtain credit or borrowings without giving a security for the loan. However, this is not possible in all cases. If the amount is significant or the lender has a policy of obtaining collateral, and the company needs funds, it will accept the lender’s requirements and provide some asset as collateral.
A payable that is NOT backed up by some collateral is known as unsecured payable. In case of default by the borrower or creditor, the lender either suffers the loss or files a lawsuit against the creditor to recover the amount due.