Collateral Coverage Ratio: What You Should Know
Now that we’ve defined collateral, let’s discuss the collateral coverage ratio. At its core, the collateral coverage ratio is the percentage of a loan that’s backed by a discounted asset. It allows lenders to figure out how much money they’d be willing to lend you.
Collateral Coverage Definition
To answer the question, “What is collateral coverage?” let’s briefly go over how financing works.
Every time a lender issues a term loan, they take on a risk. Their goal, however, is to mitigate their risk as much as possible. With collateral, they can do just that.
If you want to take out a small business loan, however, you won’t be able to offer any collateral. Your collateral must have a lower value than your loan.
The collateral coverage refers to the percentage of your loan that’s backed by a discounted asset. A lower ratio means a higher risk for a lender and the potential need for a cosigner. On the contrary, a higher ratio equates to a lower risk for a lender. With a higher ratio, you may be able to borrow more money if you need to.
Collateral Coverage Formula
Here is what the collateral coverage formula looks like:
Collateral Coverage Ratio = Discounted Collateral Value / Total Loan Amount
Discounted Collateral Value
The way a lender views the value of the collateral you offer is referred to as the discounted collateral value. They will build in a “discount” for your asset’s depreciation or the fact that it will hold less value time. Wear and tear, outdated technology, and lower real estate values can all lead to depreciation.
If a lender has to seize your asset, there’s a good chance it’s worth less than its estimated market value, which is why there’s a discount. The discount depends on the details of the loan and will likely be based on:
- Asset Type: Assets with values that are easier to verify are usually discounted less. Real estate, for example, will come with a lower discount than assets like inventory or furniture.
- Lender Type: Since banks are risk-averse, they are known to apply larger discounts than commercial lenders. Commercial lenders are often willing to take on more risk and may offer lower discounts as a result.
- Loan Type: With traditional installment loans that feature direct terms, it’s easy to figure out how much collateral is required. Cash advances and other types of credit that depend on invoice or purchase orders are known for higher discounts. This is because of the possibility of collection expenses.
Total Loan Amount
Total loan amount is the same as your loan principal or the amount of money you agreed to repay your lender. If you take out an amortizing loan with compound interest, don’t forget that you’ll have to pay off your interest before you repay your principal. This is important as this formula considers principal instead of interest.
If you take out a loan for $80,000, for example, your total loan amount is equal to $80,000. If you pay off $20,000 in principal and $5,000 in interest after the first year, your total loan amount is $60,000.
Collateral Coverage Ratio Example
Let’s say you own a landscaping company and wish to borrow $50,000; if you estimate that you have $500,000 worth of equipment. The lender, however, believes that it will significantly go down in value by 20%. Here’s what your collateral coverage ratio will look like.
(100%-90%) X $500,000) / $50,000= 1
Since most lenders prefer a ratio between 1 to 1.6, you’ll likely be in good shape and get approved for the loan. In the event your lender requires a collateral coverage ratio of higher than 1, you may have to borrow less money or work to increase your ratio.
Why to Improve Collateral Coverage Ratio
Since the collateral coverage ratio is used by lenders to determine maximum loan amounts and minimum collateral requirements, it’s very important. If your ratio is low, you may want to improve upon it. This way you can significantly increase your chances of approval.
To improve your ratio, you can pledge assets that have higher values. In addition, you can put up those with lower discounts.
Another option is to combine different assets. If you’re unable to improve your collateral coverage ratio, you may need to get a co-signer for your loan. You may also want to opt for a Small Business Administration (SBA) loan because SBA is unlikely to deny you solely because of insufficient collateral.
Don’t Overlook the Collateral Coverage Ratio
If you need to obtain financing for your business, your collateral coverage ratio should be top of mind. It can help you understand how the loan you’d like compares to the assets you have and what you’re able to afford. If you’re displeased with your ratio, improving it may be well worth your time and effort.
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