Lenders require borrowers to pledge assets as collateral for secured loans to lower the lenders’ risk. The collateral coverage ratio is a calculation that lenders often use when finalizing a secured loan. This ratio compares the value of the collateral to the loan amount.
Key Points:
- If a lender requires collateral, they often impose a collateral coverage ratio to set a maximum loan limit for borrowers.
- A higher collateral coverage ratio means less risk for the lender.
- Lenders can discount collateral requirements based on the asset type.
- Borrowers can often unlock lower rates when their collateral coverage ratio is higher.
Collateral Ratio Definition
Collateral is an asset that a borrower pledges to a lender to secure a loan. If the borrower defaults on the loan, the lender has the right to take possession of the collateral to recoup their losses, this is known as asset based lending. Depending on the loan type and your financial situation, a lender may require a collateral asset to finalize your loan.
Lenders use the collateral coverage ratio (CCR) to set maximum loan limits for borrowers.
The ratio compares the collateral asset’s discounted value against the amount borrowed.
The CCR measures the percentage of a loan backed by the discounted asset.
Many lenders set a minimum CCR at 1.0. But the CCR may be increased or decreased based on the risks presented by the borrower.
Collateral Coverage Ratio Calculation: How to Calculate Collateral Coverage Ratio
As a borrower, understanding how to calculate the collateral coverage ratio can come in handy when exploring your loan options and the types of collateral for loans.
The calculation starts with the collateral coverage formula:
Collateral Coverage Ratio = Discounted Collateral Value / Total Loan Amount
The collateral value is a fair market estimation or the value of an asset used to secure a loan. But most lenders set a discount on the collateral’s value. This is called the discounted collateral value (DCV).
For example, most mortgage lenders will discount the rate of a property’s value by 80%. With that, a property valued at $100,000 would only represent $80,000 in terms of collateral. The discounted rate protects the lender against changing market values.
The discounted collateral value varies based on the following risk factors:
Type of asset: Different types of assets come with different levels of risk. For example, real estate is usually valued at 80% of its current value. To explore this further you can take a look at asset based lending for real estate. But assets that are more difficult to liquidate, like inventory or equipment, often are discounted to between 20% to 50%.
Type of lender: The lender you are working with will impact the discounted value. For example, a traditional bank may not be willing to take on as much risk as a commercial lender or credit union. And that difference is reflected in different discounted collateral values.
Type of loan: The loan’s structure can impact the discounted value. If your loan requires more extensive collection costs, that leads to a more heavily discounted value.
Total loan amount: Although the total loan amount won’t impact your discounted collateral value, the discount will impact how much you can borrow. A smaller discounted value means that you can borrow more.
Why is the Collateral Coverage Ratio Important?
So, why should you care about the collateral coverage ratio as a borrower? It can impact your loan amount in so many different ways.
It determines how much you can borrow: A lender uses the CCR to determine maximum loan amounts. That maximum can significantly impact your plans!
CCRs vary based on the industry and the borrower: You can do some research ahead of time to see what the going rate for CCRs is in your industry and based on your credit profile. This information can help you map out a funding plan for your business.
Minimum required asset collaterals can impact your plans: If you plan to take out a loan, you’ll need to make sure you have enough assets on hand to secure your desired loan.
What is a Good Collateral Coverage Ratio?
When shopping around for a loan, it’s nice to have a benchmark to compare your loan to.
In general, lenders are looking for a minimum CCR between 1.0 and 1.6.
With a 1.0 CCR, the discounted collateral will cover the entire loan amount if the borrower defaults on the loan.
In an overcollateralized loan with a CCR value of over 1.0, the collateral will cover more than the loan amount. Essentially, this makes the loan much less risky for the lender.
For example, let’s say that a business wants to borrow $50,000. The business owns its retail store worth $75,000 outright. If the lender discounted this store as collateral by 20%, the CCR would be 1.2%.
Increasing Your Collateral Coverage Ratio
A higher collateral coverage ratio gives you options. With a higher CCR, you can likely secure a larger loan or even cross-collateralize another loan for better financing all around.
Pledge assets with higher values: If you have several assets to choose from, consider pledging an asset with a higher value to increase your CCR.
Pledge assets with lower discount rates: Not all assets are equal in the eyes of lenders. Consider pledging an asset that has a lower discount rate. For example, if you have the choice to pledge either inventory or real estate, you’ll likely boost your CCR by choosing real estate as collateral.
Choose multiple assets: Many lenders will allow you to pledge multiple assets for the same loan. If you have more assets to pledge, consider adding them together to increase your CCR.
Conclusion
The collateral coverage ratio may seem like a small number, but it can have a big impact on your loan. Lenders want to see a high CCR of at least 1.0 to ensure that the discounted collateral will cover the outstanding loan costs.
If you are considering a secured loan, then check out the top lenders today.
