What Is Collateral Value?
The term collateral value refers to the fair market value of the assets used to secure a loan. Collateral value is typically determined by looking at the recent sale prices of similar assets or by having the asset appraised by a qualified expert.
What Is Collateral?
- Collateral value refers to the amount of assets that have been put up to secure a loan.
- This value is often used by lenders to estimate the level of risk associated with a particular loan application.
- Various methods are used to estimate collateral value. These can include reviewing comparable transactions, relying on tax assessments, and consulting with subject-matter experts.
Understanding Collateral Value
Collateral value is one of the key aspects considered by lenders when reviewing applications for secured loans. In a secured loan, the lender has the right to obtain ownership of a particular asset—called the "collateral" of the loan—in the event that the borrower defaults on their obligation. In theory, the lender should be able to recover all or most of their investment by selling the collateral. Therefore, estimating the value of that collateral is a key step before any secured loan is approved.
Loan to Value Ratios
The size of a secured loan relative to its collateral value is known as the loan-to-value ratio (LTV). For example, if a bank provides an $800,000 loan in order to purchase a house with a collateral value of $1 million, then its LTV ratio would be 80%.
Secured loans can be made against all types of property. One of the most common types of secured loan is the home mortgage, in which the house is given as collateral to secure the mortgage loan. In this situation, if the borrower fails to make their mortgage payments, the mortgage lender can sell the house in order to recuperate their investment. The collateral value of the house, meanwhile, is typically determined by relying on an appraiser who specializes in real estate. Other valuation metrics, such as recent tax assessments or comparable transactions, may also be consulted.
Real World Example of Collateral Value
Depending on the type of asset being used as collateral, the methods for assessing collateral value may differ. For instance, if a loan is being secured by publicly-traded stock, then the current market price of those securities can be used when estimating its collateral value.
In other cases, the collateral being used may be rarely traded on the market. For instance, a borrower might pledge collateral in the form of privately held shares or alternative assets, such as fine art or rare collectors items. In these situations, an appraiser may need to use specialized valuation methods, such as calculating the value of the private shares by using discounted cash-flow analysis (DCF). Fine art and other rare items, meanwhile, may need to be appraised by specialists who are familiar with the private collector and auction markets for those types of assets.
Typically, the size of the loan provided by a lender will range from 70 to 90% of its collateral value. For instance, in the case of mortgage loans, lenders have traditionally offered 80% financing, which means that the borrower will need to provide a 20% down payment. However, the exact size of the loan will depend on several factors, such as the perceived reliability of its collateral value, the current state of the market, and the borrower's credit rating.