Wednesday, December 18, 2013

Everything You Wanted to Know About Collateral

COLLATERAL CAN BE A KEY FACTOR in determining a borrower's ability to get a loan. Although it's not the only factor that a lender will consider, collateral is a concept that every borrower, broker, Finder and consultant must understand in order to obtain loans successfully.
WHAT IS COLLATERAL? Collateral is a form of security for a loan. When a borrower pledges collateral as security for a loan, it reduces or eliminates problems the lender might face if the borrower cannot, or does not, repay the loan as they originally agreed to do. A borrower who doesn't repay a loan as promised is in default.
IF THE BORROWER DEFAULTS, the lender can take the collateral and sell it to get back some or all of the money the borrower owes. Because securing the loan with collateral lowers the lender's risk, the lender may be more likely to make the loan.
COLLATERAL CAN HELP A BORROWER get a loan even if the borrower has a less-than-perfect credit score or a limited credit history. Additionally, a loan secured by collateral may come with:
  • lower interest rates
  • fewer transaction fees
  • better terms
  • more favorable repayment periods
COLLATERAL MAY BE COMBINED with other forms of security, such as cash in a savings account or money owed to a business, to show the lender that the borrower has additional ways to repay the loan.
  • land
  • homes
  • buildings
  • vehicles
  • equipment
  • jewelry
  • stocks and bonds
  • business inventory (materials and products)
  • accounts receivable
ASSETS MAY BE OWNED BY an individual (personal collateral) or by a business (business collateral).
FOR COLLATERAL TO BE ACCEPTED BY A LENDER, the borrower must have some form of proof (typically called a title) which shows the lender that the borrower owns all or part of the collateral. Thus, collateral may be based on paper assets, often referred to as notes.
  • a Certificate of Title to a building
  • a Deed to a piece of land
  • stocks in the owner's name
  • a receipt showing the borrower “has title” to the asset being pledged as collateral
COLLATERAL CAN ALSO BE BASED ON EXPECTED ASSETS, as in the case of an investment or accounts receivable (money that is owed to a business).
ASSETS FINANCED WITH BORROWED FUNDS can sometimes be used as collateral. For example:
  • a property that a borrower wants to buy may itself serve as collateral,
  • because the lender can repossess and sell the property if the borrower defaults
  • similarly, a building or piece of land may generate income for the borrower
  • a loan based on this kind of real estate is often called a hard money loan
IF A BORROWER ALREADY HAS A MORTGAGE on an existing property or a loan on a vehicle, the lender might accept these assets as collateral, but the total value of the collateral may depend on how much of the original loan has been paid (called equity). It's also possible that a borrower might own only a portion of the collateral together with another person or business. This introduces added complexities.
BORROWERS, BROKERS, FINDERS AND CONSULTANTS SHOULD BE AWARE that the borrower risks losing the collateral if they fail to repay the loan, so it's important to carefully review the risks of using certain assets as collateral before pledging them to the lender.
IF THE BORROWER CAN'T AFFORD TO LOSE THE COLLATERAL, such as his home, he should think twice before pledging the asset as collateral. Why? Because if the borrower defaults, he could wind up losing not only the existing property being used as collateral, but also any new property he hopes to buy with the loan that the collateral is meant to secure.
LENDERS TYPICALLY APPRAISE THE COLLATERAL to decide how much they think it's worth. Borrowers should realize that lenders may appraise an asset at a value lower than the borrower expects or believes the asset is worth. It's also possible that the lender's appraisal will be lower than the value set by the city or county for the purpose of collecting taxes on the property.
IF THE BORROWER DISAGREES with the lender's appraisal, she has two options:
  1. seek a loan from a different lender or
  2. appeal the lender's appraisal and ask for an appraisal review (reappraisal)
IN SOME CASES A LENDER WILL REAPPRAISE THE PROPERTY at a higher value. If the appraisal is too low, the borrower might be able to talk the lender into offering a lower interest rate or adjusting some other aspect of the loan to make it more attractive to the borrower.
COLLATERAL CAN DECREASE IN VALUE due to any number of factors, such as:
  • deterioration of the property over time or
  • fewer people wanting to move to the area where the property is located
IN OTHER CASES, THE VALUE OF COLLATERAL CAN GO UP, as with investments that earn money over time.
IF THE COLLATERAL DECREASES IN VALUE and the borrower defaults on the loan, the borrower may still have to repay the amount at which the collateral was appraised. For example, a home might initially be appraised at $100,000 and then decrease in value to $75,000 a few years later.
IF THE HOUSE WAS USED AS COLLATERAL to get a $100,000 loan, the borrower must still pay back the $100,000, even if the house is now worth $75,000. If the lender sells the house for $75,000, the borrower owes the lender $25,000. This can put the borrower in hot water if he or she doesn't have the $25,000.
IT'S USUALLY WISE TO BORROW LESS than the full value of the collateral to avoid the problem just described. If the amount of the loan is less than the value of the collateral, the borrower and lender are better protected and the risk of losing money is lower for them both. This makes it easier for the lender to make the loan.
IF A BORROWER HAS MADE PAYMENTS ON A PROPERTY reliably over a period of time—usually for at least a year—the collateral is said to be seasoned. Lenders prefer seasoned collateral because it further helps to assure them that they'll get back the money they loaned out.
A LENDER WON'T NECESSARILY REFUSE TO MAKE A LOAN just because a borrower lacks collateral. If the borrower has money in the bank, a history of paying bills on time or is willing to accept a higher interest rate on the loan, the borrower might still have a chance of getting the loan they want.
BEFORE GOING TO A LENDER FOR A LOAN, make a list of all the borrower's assets that might be offered as collateral. Carefully assess the value of each item. Look up the value given in sources such as the city's tax assessment and on real estate websites, the “Blue Book” value (for vehicles), and the ticker tape price and earnings (for stocks and bonds).
THESE ARE JUST A FEW OF THE MANY POSSIBLE KINDS of collateral and the ways of judging their value. With a good knowledge of all the assets that the borrower might be able to pledge as collateral, the borrower and his agent can approach lenders with confidence while increasing the chances of getting the loan that the borrower seeks.
The article was previously published in Money Watch Bulletin.
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