Whether it's a lender trying to sound optimistic about the outcome of a loan, or a prospective borrower making a case for why his loan should be granted, we've heard a common refrain over the years:
“Don’t worry, there’s lots of collateral.”
Unfortunately, these are frequently famous last words.
Collateral is the third C of lending (learn about the second C here) and is definitely taken into consideration during the business loan decision process, but it is not the only or even most important aspect involved in the overall process. As we have said before, the obvious goal in lending is to be repaid. The reason to legally secure a loan with collateral is to have a secondary or even tertiary source of repayment in the event that the borrower incurs unforeseen events that hinder their ability to repay the debt.
Collateral Approval in Lending
In order for collateral to provide a source of repayment, the pledged asset has to be converted to cash and this process of liquidation, depending on what the collateral may be, can be very time consuming and expensive. The lender may find out that many of the business assets that they have a security interest in have little or no actual value that can be used to repay the debt.
One of the first decisions to be made in the approval process will include – What type of assets are available as collateral and what is the value? What discount should the lender apply to each asset class? Banks will normally have loan policies that they are expected to adhere to. They may want to loan only 50% on inventory and 70% on accounts receivable, etc. If equipment is involved, if it is specialized and has a limited marketability becomes a relevant factor. Locating collateral and taking possession of the collateral may be difficult and expensive. Sometimes it may be difficult for a business owner to understand this side of the equation when he or she is focused on the original cost of machinery, equipment, fixtures and inventory.
Real Estate Collateral
Historically, real estate lending has been a primary component of economic “booms and busts”. The Savings and Loan Crisis of the late 1980’s saw real estate values plummeting, financial institution failures and foreclosures all become a common place occurrence. More recently, the housing bubble burst, resulting in tremendous losses for many housing lenders and agencies, coinciding with a severe decline in real estate values in many areas of the country. Real estate is often regarded as the best type of collateral, as it offers the least amount of risk for a lender, but in reality a concentration of real estate loans has proven to be the downfall of many financial institutions.
Loans secured by real estate will also have “loan to value” requirements based on the type of real estate. Another consideration is what is the best way to value the collateral? When real estate is taken as collateral, there are appraisal regulations and other accepted guidelines in determining what the collateral value may be. As mentioned previously, the “value” of real estate collateral may vary widely due to time and circumstances. As with other types of collateral, the liquidation value of real estate collateral or what is eventually left to be paid on the debt is uncertain and determined by many factors. The costs of foreclosure, holding and repair costs, the condition of improvements to the property, and marketing and brokerage costs to sell the property must all be considered when putting up real estate for collateral.
Ultimately, collateral is an important component of the credit decision, but when an individual or business is in need of credit as a necessary and prudent part of their business plan, it is always a good idea to give the other four “C”s of lending the necessary consideration. The past is strewn with the skeletons of many who said, “Don’t worry, there is lots of collateral”.