An advance rate is the maximum percentage of the value of a collateral that a lender is willing to extend for a loan. The advance rate helps a borrower determine what kind of collateral to bring to the table to secure the desired loan amount – and helps minimize a lender's loss exposure when accepting collateral that can fluctuate in value.
Breaking Down Advance Rate
Collateral helps lenders minimize risks and to offer affordable interest rates to borrowers. By setting an advance rate, a lender can build a cushion into the loan transaction by ensuring that if the value of the collateral drops and the loan goes into default – there is still adequate protection from the loan principal loss. If a lender has an advance rate of 75%, and the value of collateral presented is $100,000, then the maximum loan the borrower can receive is $75,000.
Collateral helps borrowers secure a better rate for their loan – and potentially a larger loan altogether. Common types of collateral include real estate (including home equity), automobile vehicles, cash accounts, investments, insurance policies, future payments or receivables, valuables, and/or machinery and equipment.
The advance rate works similarly to the loan-to-value (LTV) ratio. LTV is another lending risk assessment ratio often used by financial institutions and others lenders prior to approving a mortgage. High LTV ratios are generally deemed to be higher risk, subsequently costing the borrower more and potentially requiring the borrower to purchase mortgage insurance. The LTV ratio can be calculated as the Mortgage Amount / Appraised Value of the Property.
Advance Rate in the Context of Assessing Credit Risk
Determining the advance rate for a borrower usually comes after the lender analyzes the overall financial condition of the borrower. This analysis focuses on the ability of the lender to repay the proposed loan, according to the specific terms and conditions given. To determine a borrower’s credit risk, lenders, such as commercial banks, often begin with a framework, called “the five Cs.” These consist of an applicant's credit history, his capacity to repay, his capital, the loan's conditions, and associated collateral.
Credit risk assessment occurs not only in cases of consumer loans but also throughout the bond market. Following careful consideration of a bond issuer’s (company, non-profit, municipality, etc.) risk of default, a credit rating agency, such as Fitch, Moody’s, or Standard & Poor’s, assigns a rating, which corresponds to the issue’s risk level and corresponding potential for reward.