Collateral may be defined as property that secures a loan or other debt, so that the property may be seized by the lender if the borrower fails to make proper payments on the loan.
When lenders demand collateral for a secured loan, they are seeking to minimize the risks of extending credit. In order to ensure that the particular collateral provides appropriate security, the lender will want to match the type of collateral with the loan being made. For example, the useful life of the collateral will typically have to exceed, or at least meet, the term of the loan; otherwise the lender's secured interest would be jeopardized. Consequently, short-term assets such as receivables and inventory will not be acceptable as security for a long-term loan, but they are appropriate for short-term financing such as a line of credit.
In addition, many lenders will require that their claim to the collateral be a first secured interest, meaning that no prior or superior liens exist, or may be subsequently created, against the collateral. By being a priority lien holder, the lender ensures its share of any foreclosure proceeds before any other claimant is entitled to any money.
Properly recorded security interests in real estate or personal property are matters of public record. Because a creditor wants to have a priority claim against the collateral being offered to secure the loan, the creditor will search the public records to make sure that prior claims have not been filed against the collateral. If the collateral is real estatepersonal property
In startup businesses, a commonly used source of collateral is the equity value in real estate. The borrower may simply take out a new, or second, mortgage on his or her residence. In some states, the lender can protect a security interest in real estate by retaining title to the property until the mortgage is fully paid.
To further limit their risks, lenders usually discount the value of the collateral so that they are not extending 100 percent of the collateral's highest market value. This relationship between the amount of money the bank lends to the value of the collateral is called the loan-to-value ratio. The type of collateral used to secure the loan will affect the bank's acceptable loan-to-value ratio. For example, unimproved real estate will yield a lower ratio than improved, occupied real estate. These ratios can vary between lenders and the ratio may also be influenced by lending criteria other than the value of the collateral; e.g., a healthy cash flow may allow for more leeway in the loan-to-value ratio. A representative listing of loan-to-value ratios for different collateral at a small community bank is:
- Real estate: If the real estate is occupied, the lender might provide up to 75 percent of the appraised value. If the property is improved, but not occupied (e.g., a planned new residential subdivision with sewer and water, but no homes yet), up to 50 percent. For vacant and unimproved property, 30 percent.
- Inventory: A lender may advance up to 60 percent to 80 percent of value for ready-to-go retail inventory. A manufacturer's inventory, consisting of component parts and other unfinished materials, might be only 30 percent. The key factor is the merchantability of the inventory — how quickly and for how much money could the inventory be sold.
- Accounts receivable: You may get up to 75 percent on accounts that are less than 30 days old. Accounts receivable are typically "aged" by the borrower before a value is assigned to them. The older the account, the less value it has. Some lenders don't pay attention to the age of the accounts until they are outstanding for over 90 days, and then they may refuse to finance them. Other lenders apply a graduated scale to value the accounts so that, for instance, accounts that are from 31-60 days old may have a loan-to-value ratio of only 60 percent, and accounts from 61-90 days old are only 30 percent. Delinquencies in the accounts and the overall creditworthiness of the account debtors may also affect the loan-to-value ratio.
- Equipment: If the equipment is new, the bank might agree to lend 75 percent of the purchase price; if the equipment is used, then a lesser percentage of the appraised liquidation value might be advanced. However, some lenders apply a reverse approach to discounting of equipment: they assume that new equipment is significantly devalued as soon as it goes out the seller's door (e.g., a new car is worth much less after it's driven off the lot). If the collateral's value is significantly depreciated, loaning 75 percent of the purchase price may be an overvaluation of the equipment. Instead, these lenders would use a higher percentage loan-to-value ratio for used goods because a recent appraisal value would give a relatively accurate assessment of the current market value of that property. For example, if a three-year-old vehicle is appraised at $15,000, that's probably very close to its immediate liquidation value.
- Securities: Marketable stocks and bonds can be used as collateral to obtain up to 75 percent of their market value. Note that the loan proceeds cannot be used to purchase additional stock.
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