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Collateral is one or more assets pledged to secure a loan. If the borrower defaults on the loan, the lender can seize and sell collateral in order to recover its money. Because collateral makes lending less risky, it facilitates a borrower’s ability to get a loan and helps determine the maximum loan amount.
Collateral Coverage Ratio Definition and Calculation
The collateral coverage ratio (CCR) compares the value of the collateral to the loan amount:
Collateral Coverage Ratio = Discounted Collateral Value / Total Loan Amount
The minimum acceptable CCR is typically 1.0.
Discounted Collateral Value (DCV)
DCV is the current value of the asset, based on an appraisal or an estimate of its fair market value, discounted by a certain percentage. For example, a building might have a fair market value—that is, the price it would fetch at an auction—of $1 million. A lender might have a policy of discounting real estate collateral by 20%, so the discounted collateral value of the building would be:
DCV = (100% - 20%) x $1 million = $800,000
The building would collateralize a loan of up to $800,000 given a required CCR of 1.0.
The discount factor varies from loan to loan based on several risk factors:
- Type of asset: Assets with a stable and easily verified value will be discounted less. Real estate will usually be valued at 80% of current value, whereas assets like inventory, equipment or furniture that are harder to value or harder to liquidate might receive a discount factor of 30% to 50%. Perishable inventory might be valued at only 10% to 20% of current value because of spoilage risk.
- Type of lender: Banks might assign discount factors differently from commercial lenders. That’s because banks are often risk-averse, and therefore would want to apply a larger discount, as this will ultimately reduce the size of the loan and therefore reduce the bank’s risk. A commercial lender might be more willing to take on risk and therefore discount property less. Thus, a bank might value real estate at 80%, whereas a commercial lender might use 85%.
- Type of loan: A term loan normally has straightforward terms, and it is easy to determine the amount of collateral needed to secure the loan. Other types of credit, such as cash advances based upon purchase orders or invoices, are more heavily discounted because of possible collection costs.
The general rule is to discount the current value of the collateral. One exception deals with hard money real estate loans for fix-and-flip properties. Hard money lenders typically value the underlying property serving as collateral at its anticipated value after rehabilitation is complete. These lenders might compensate for this higher valuation by discounting the property more.
For example, consider a foreclosed home with a current value of $300,000. A flipper would like to buy the home, rehab it for $75,000 and then sell it for $400,000. The flipper receives two loan offers:
Bank: The bank has a CCR of 1.0 and applies a 20% discount. The amount of money it will lend for a short-term real estate loan will be:
Total Loan Amount = DCV / CCR = ((100% - 20%) x $300,000) / 1.0 = $240,000
The flipper would have to put up $60,000 in additional equity plus $75,000 to cover rehab costs, or $135,000.
Hard money lender: The lender uses a required CCR of 1.0 and a discount factor of 25% applied to the post-rehab value of the property:
Total Loan Amount = ((100% - 25%) x $400,000) / 1.0 = $300,000
The flipper would need contribute only $75,000 to the project instead of $135,000 and decides to take this route, even though the hard money lender charges a higher interest rate than does the bank.
Total Loan Amount
The TLA is equal to the loan principal and does not include the interest charged on the loan. The more collateral that the borrower can supply, the larger the potential size of the loan.
What’s an Acceptable Collateral Coverage Ratio?
A rule of thumb is that lenders look for a minimum CCR between 1.0 and 1.6. A value of 1.0 means that the discounted collateral will cover the entire loan amount in the case of default, while a higher value overcollateralizes the loan, making it less risky.
For example, John’s Plant Nursery is looking to borrow $75,000 and can offer several types of collateral:
Real estate: John can pledge a retail store/greenhouse as collateral. John owns this property outright, having paid off its mortgage. The current market value of the property is $250,000 and the bank will discount it by 20%. The CCR would be:
CCR = ((100% - 20%) x $250,000) / $75,000 = 2.67
Inventory: John estimates his current inventory to be worth $300,000. However, the bank will heavily discount it because of its perishability, valuing it at only 10% of its market value:
CCR = ((100% - 90%) x $300,000) / $75,000 = 0.40
Equipment: John owns several pieces of equipment, including a tractor, three trucks, a forklift and other items. Together they are valued at $150,000. The bank will apply a discount factor of 50% on these:
CCR = ((100% - 50%) x $150,000) / $75,000 = 1.00
The bank requires a CCR of 1.0 for collateralized loans.
John decides to pledge his equipment as collateral. Pledging his real estate would be overkill, while his inventory, although the most valuable asset before discounting, is insufficient collateral because of heavy discounting.
How You Can Improve Collateral Coverage Ratio
A business owner interprets CCR as helping to determine the amount of money that can be borrowed and the minimum amount of required collateral. A high CCR means the borrower has a better chance of getting the loan and that the collateral will pay off the loan in the case of default without putting other assets at risk. If the CCR exceeds the minimum required by the lender, the pledged asset might be used to refinance the loan or to cross-collateralize another loan. In addition, a high CCR means that the borrower might be able to secure a larger loan.
If your CCR is too low to secure a loan for the amount you need, you might be able to increase your CCR with these actions:
- Pledge more valuable assets: You might have a choice of different assets, some with higher CCRs.
- Pledge less-discounted assets: You might have two assets with the same current value, but the first is more heavily discounted than the second. You increase your CCR if you pledge the second asset instead of the first.
- Combine assets: You can pledge several different assets to boost your CCR into an acceptable region.
Other remedies a borrower might consider is to get a co-signer for the loan, which might reduce the required collateral, or to borrow using an SBA-guaranteed loan, which will not be declined solely on the basis of inadequate collateral.
From the lender’s viewpoint, a high CCR is necessary to ensure loan collection. A value of 1.0 or higher means that the discounted collateral will fully repay the loan. Using too high a CCR becomes unproductive, as it might exclude too many creditworthy borrowers or cause potential borrowers to seek alternative lending sources.