Collateral Definition, Meaning and Example
KMedia Work Shop July 2018
Collateral is a tangible asset that a borrower offers a lender as a way to secure a loan. If during the lifetime of the loan the borrower stops making payments, the lender can seize control of the collateral and sell it.
Collateral Benefits for Borrowers and Lenders
Adding collateral to a loan can help reduce the interest rate charged by the lender. Collateral can help improve a borrower’s chance of securing a loan if he or she doesn’t have a great credit rating. For the lender, the inclusion of collateral in a loan helps protect downside. The lender has the added security of knowing that if the borrower can’t repay the loan, the lender can recoup part or all of the loan amount from the collection and sale of the collateral.
Here’s a Hypothetical Example:
Tired of working in the banking industry, Douglas decides to follow his dream and open a Health & Wellness food truck in the heart of the CBD in Sydney. The truck Douglas wishes to purchase costs $100,000. However, Douglas can only afford to put up $30,000 of his own money, opting to borrow the remaining $70,000 from the bank.
For the bank to lend Douglas such a large amount relative to the value of the truck, the bank needs a way to protect itself in case Douglas can’t pay back the loan. The bank requires Douglas to pledge the food truck as collateral for the loan. By willing to provide the truck as collateral, this helps lower the interest rate charged by the bank.
Things had been going well with the new venture, but soon sales slipped and Douglas found himself unable to make the monthly loan payments to the bank. As a result, the bank seize control of the food truck, and tries to find a buyer for the food truck in an attempt to recoup their money.
Adding collateral to a loan reduces risk for the lender. If the value of the collateral is greater than the amount to be borrowed, it is considered a secured loan. In the opposite situation, where the loan value is greater than the value of the collateral, the loan is considered unsecured. Unsecured loans tend to carry higher interest rates than secured loans as the risk to the borrower is greater.
Other Aspects to Evaluating Collateral
While there are a variety of variables that lenders consider when granting a loan, here are two that we find important: LTV and DSCR.
To reduce risk, borrowers can seek out loans that have a low loan-to-value (LTV) ratio. LTV is the ratio between the loan amount and the diligenced value of the underlying asset. In the example above, the LTV would be $70,000/$100,000, or 0.7. Thus, all else equal, a lower LTV is a more secure loan.
A lender can also look at a borrower’s debt service coverage ratio (DSCR) to determine the borrower’s ability to repay the loan. This ratio measures the cash flow available to service the debt and is calculated by dividing a business’s net operating income by their outstanding debt obligations. The higher this ratio is, the more likely a borrower will be able to pay back a loan.
At Kiribilli Private all of our investment offerings are backed by collateral. This helps reduce downside by helping protect principal. Aircraft Leasing offerings are backed by physical aircraft. In litigation offerings, for example, collateral can take the form of claims on future proceeds from a settled or pre-settled case. In Marine Finance, the dry bulk vessels serve as collateral and in Patent Monetarization Finance the commercial value of the Patent/s are offered as collateral.