All borrowers have a unique situation when applying for a loan. By using the 5Cs of credit, lenders can evaluate the strengths and weaknesses of each situation individually. The factors taken into consideration are, character, capital, capacity, collateral and conditions. This series takes an in depth look at each individual criteria. This is the fourth installment, which discusses the importance of collateral.
When securing a loan, collateral is considered a secondary source of repayment; the primary source being cash flow. Collateral is made up of assets such as real estate, livestock and equipment that can be pledged to the lender as a form of security in case a borrower fails to pay back the loan. The lender would be able to liquidate the assets and use the money to retire the loan.
Assets that are usually included as collateral, depending on the type of loan, are real estate, livestock, equipment and vehicles. Operating loans for annual recurring expenses or purchase of livestock for resale will usually be secured by livestock, possibly stored crops, or equipment. For intermediate term loans (term of 2-7 years) machinery, breeding livestock and vehicles can be used as collateral. Long term loans for real estate and improvements are usually amortized over 10-30 years.
The margin of value is an important factor that lenders look at when considering collateral. Typically, a lender wants the amount of collateral to exceed the amount of the loan, rather than lending dollar for dollar. Loan-To-Value (LTV) is the loan amount as a percentage of collateral value and will vary from lender to lender. The LTV for a real estate loan may vary from 60 percent to 80 percent depending on the frequency of payments and loan term. For example, a loan with monthly payments versus annual payments may be approved at a higher percent LTV. Also, a loan for a 15 year term may be approved at a higher percent LTV than a loan for a 30 year term.
In order to determine the value of a potential borrower’s collateral, all assets to be considered collateral must be evaluated by a qualified appraiser. The lender will order the appraisal which might be completed by an employee of the lending institution or a contracted appraiser. For instance, with cattle and machinery the lender will usually do a chattel evaluation and assign values to the property.
If all the other criteria for lending are strong, you are an excellent candidate for the loan you are applying for. Collateral can come in to play if some of the other areas show signs of weakness. It can give the lender the security and confidence they need to approve your application.
Roger Ash is a Vice President with FCS Financial in Lebanon, Mo.
