Collateral Value

What Is Collateral Value?

Collateral value is the fair market value of the assets that a borrower might take as collateral to secure a loan.

Have you ever taken out a loan? For a house, a car, or maybe you wanted to start a business? Well, if you wanted to do any one of those things, chances are you’ve taken out a loan to do those things.

A loan is a form of credit. And lenders (Banks) give out money to borrowers (You) and expect you to repay that money you owe. But what if you don’t pay back the money, or you can’t? 

Well, if that happens, the bank will collect the collateral you put up. 

Collateral is a safeguard for banks. A guarantee that they will collect something from you even if you can’t pay back your loan. 

Often, this can be a car, maybe a house, or other assets. Either way, any assets put up have to have value. How else can a bank be sure their money is secured?

The price determines the value. If a bank gives a loan for $100,000, they would like to have assets to back up the loan in case the loan fails. 

If the loan does fail (the borrower can’t pay back the loan), the bank will then take whatever assets are put up and often sell them to many back any money they lost. 

While most loans don’t have these safeguards, loans with risky borrowers are almost guaranteed to have some form of asset backing.

Collateral Value in Loans 

To understand what collateral is, it's necessary to understand the risk of a loan. Loans are an amount of money given to a borrower with the agreement that they will pay back the lender with interest (the cost of borrowing money).

Lenders and borrowers agree to an agreement on the loan. This agreement will decide how the borrower will repay their loan, when, and how much interest the borrower will pay. It will also decide other factors such as terms, additional costs, and other special conditions.

But this lent money comes with implied risk. What happens if the borrower doesn’t pay back the loan? What if the borrower loses their job? These factors add risk to the lender. In case something happens, the lender won’t get their money back.

Because of this implied risk, loans are often given out to only those who have a good credit score or people with a history of paying back their loans. This way, banks can ensure that most of the money returns to them. But sometimes, banks gamble with riskier borrowers. 

Even if a borrower isn’t risky, collateral can serve as a way for people to persuade a bank to give them a loan. If a portion of the loan is covered, it would make it much easier for a person to take out a loan. 

Why are loans secured with Collateral?

Most loans are often secured. Especially if a borrower is deemed to be a risky investment, banks won’t lend out money if they believe they won’t get it back. Generally, banks will only give loans to those they think will pay back their loans.

But sometimes, even banks will give loans to riskier borrowers. To secure a bank's money, they can put the loan against collateral. This system allows the bank to secure a payment even if the borrower forfeits their loans. 

In this type of agreement, the borrower will agree to put up something they own, like a house or anything else with tangible value. If you take out a mortgage, you'll probably put up a home and a car if you take out a car loan.

Even raw materials can be put up. Items such as metals, food/perishables can be taken by the bank to be sold.

These assets serve as a safety net for most banks. This net ensures that the bank won’t lose profit. This insurance also helps to prompt banks to give out more loans. This increase will not only improve the rate at which a bank can make a profit but also push our economy. 

How to value collateral?

Most banks value different assets differently. Some banks that work with investment firms often value securities higher than other banks, while those with ties to industrial companies would value raw materials more.

Although there is fluctuation in the pricing of collateral, they all follow the basic market price of a good. The market value would be the deciding value. 

A bank often looks to see how easily it can sell assets. It would be an inconvenience to be stuck with materials or a car when they can’t sell it. 

Some banks value equipment as well. Although a bank won’t use large manufacturing equipment in their operations, companies that work in large sectors of the market often use the same, if not similar, equipment. 

Banks can take machinery or equipment and resell it to other companies to make back a loan. 

Even when a loan is backed by an asset, that can be subjected to change. What happens when the value of an asset drops? What would the bank do? Well, the bank would demand that a borrower pay back the loan. 

If the borrower is unable to pay back the loan, the bank could freeze the loan, they could demand the borrower add more assets as collateral, or that the loan be paid back in full.

Declining asset value is often seen in loans backed by securities; due to the volatility of some securities, most banks ask for collateral over the value of the loan. 

Generally, tangible assets like real estate, vehicles, or machinery don’t drop in value often. But in cases where they do (Such as the 2008 Housing Market Crash), borrowers will have to find other assets to put up. 

Collateral Collection Challenges

Although loans can be backed by collateral, some borrowers have unsavory attitudes towards collection. Multiple people will try to deny banks from collecting their assets.

In multiple instances, borrowers will obstruct banks from arriving at their houses to collect and put assets up. There are even cases where individuals will destroy their assets before a bank can collect them.

Most banks will employ people specifically trained to detain or reimburse assets promised. In most cases, they will go to the borrower's house and demand they pay back their loan, or they will take the assets that were put up as collateral. 

These situations can become hostile. Most borrowers who are unwilling to let go of an asset will turn to taunt, slander, and even violence to ensure their possessions. There are even YouTube channels dedicated to recording these encounters. 

A person must allow a bank to repossess the promised collateral. Even though the process can heavily damage your financial security, it’s best to have a good relationship with banks rather than a hostile one.

If a bank knows that you are unwilling to part with promised collateral, this can make it nearly impossible to secure a loan in the future or even work with banks in the future. Actions such as these will be remembered in your credit history and possibly on a criminal profile.

Factors affecting the collateral value

Each loan is different, and each bank is too. No loan is going to require the same amount of backing.

But some factors can change how much you need to put up.

1. Credit Score: Your credit score is the aggregate score of your credibility. Your credit score goes up when you pay back your loans and debt. This score is proof that you can pay back your loans and debt on time. 
   • The higher your score is, the more willing a bank is to allow you to borrow a loan without needing collateral or needing less.
2. Capacity to Pay: Your capacity to pay is a borrower's ability to repay a loan. This looks at your income and possibly your savings. Your ability to pay shows the bank that you have to money to make monthly payments.
3. Availability of Capital: Availability of Capital or the amount of money you have on your right now. When you are financially secure, it shows the bank that you are responsible. 
4. Conditions: The overall health of the economy of the time will almost always affect loans. If the economy goes down, the bank will too. If the bank is dealing with financial hardship, it would be less likely to give out loans without backing. 
5. Valuation: As stated before, most banks will value different assets differently. They might even take an asset for less than market value. For example, if a house is worth $100,000, a bank may only value it for $80,000 in case they can’t sell the house for market price. 
   • These evaluations not only increase the amount of collateral required to take out a loan but also each of these factors do overlap with each other.

If one of these factors is amiss, it could heavily influence your ability to take out a loan or the needed amount of collateral to secure a loan. A financially smart investor would be wise to keep track of each of these factors yearly or even quarterly.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Degree of Financial Leverage
• Degree of Operating Leverage
• Degree of Total Leverage
• Effective Annual Rate
• Fractional Banking